<PAGE> 1
As filed with the Securities and Exchange Commission on July 20, 1999
Registration No. 333-78495
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
------------------------
AMENDMENT NO. 3
TO
FORM S-1
REGISTRATION STATEMENT
UNDER
THE SECURITIES ACT OF 1933
------------------------
N2H2, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
<TABLE>
<S> <C> <C>
WASHINGTON 7375 91-1686754
(STATE OF INCORPORATION) (PRIMARY STANDARD INDUSTRIAL (I.R.S. EMPLOYER INDUSTRIAL
CLASSIFICATION CODE NUMBER) IDENTIFICATION NUMBER)
</TABLE>
900 FOURTH AVENUE, SUITE 3400
SEATTLE, WASHINGTON 98164
(206) 336-1501
(ADDRESS, INCLUDING ZIP CODE AND TELEPHONE NUMBER, INCLUDING AREA CODE, OF
REGISTRANT'S PRINCIPAL EXECUTIVE OFFICES)
PETER H. NICKERSON
PRESIDENT, CHIEF EXECUTIVE OFFICER AND CHAIRMAN OF THE BOARD
N2H2, INC.
900 FOURTH AVENUE, SUITE 3400
SEATTLE, WASHINGTON 98164
(206) 336-1501
(NAME, ADDRESS, INCLUDING ZIP CODE AND TELEPHONE NUMBER, INCLUDING AREA CODE, OF
AGENT FOR SERVICE)
------------------------
COPIES TO:
<TABLE>
<S> <C>
MICHAEL E. MORGAN, ESQ. GREGORY B. ABBOTT, ESQ.
JIM D. JOHNSTON, ESQ. THOMAS B. YOUTH, ESQ.
ERIC S. CARNELL, ESQ. DOUGLAS H. HAEUBER, ESQ.
LANE POWELL SPEARS LUBERSKY LLP COOLEY GODWARD LLP
1420 FIFTH AVENUE, SUITE 4100 4205 CARILLON POINT
SEATTLE, WASHINGTON 98101-2338 KIRKLAND, WASHINGTON 98033
(206) 223-7000 (425) 893-7700
</TABLE>
------------------------
APPROXIMATE DATE OF COMMENCEMENT OF PROPOSED SALE TO THE PUBLIC:
As soon as practicable after the effective date of this registration statement.
------------------------
If any of the securities being registered on this Form are to be offered on
a delayed or continuous basis pursuant to Rule 415 under the Securities Act of
1933, check the following box. [ ]
If this Form is filed to register additional securities for an offering
pursuant to Rule 462(b) under the Securities Act, check the following box and
list the Securities Act registration statement number of the earlier effective
registration statement of the same offering. [ ]
If this Form is a post-effective amendment filed pursuant to Rule 462(c)
under the Securities Act, check the following box and list the Securities Act
registration statement number of the earlier effective registration statement
for the same offering. [ ]
If this Form is a post-effective amendment filed pursuant to Rule 462(d)
under the Securities Act, check the following box and list the Securities Act
registration statement number of the earlier effective registration statement
for the same offering. [ ]
If delivery of the prospectus is expected to be made pursuant to Rule 434,
check the following box. [ ]
------------------------
CALCULATION OF REGISTRATION FEE
<TABLE>
<S> <C> <C> <C> <C>
- --------------------------------------------------------------------------------------------------------------------------
- --------------------------------------------------------------------------------------------------------------------------
PROPOSED MAXIMUM PROPOSED MAXIMUM
TITLE OF EACH CLASS OF AMOUNT TO BE OFFERING PRICE AGGREGATE OFFERING AMOUNT OF
SECURITIES TO BE REGISTERED REGISTERED(1) PER SHARE(2) PRICE(2) REGISTRATION FEE(3)
- --------------------------------------------------------------------------------------------------------------------------
Common Stock, no par value........ 5,175,000 $12.00 $62,100,000 $17,264
- --------------------------------------------------------------------------------------------------------------------------
- --------------------------------------------------------------------------------------------------------------------------
</TABLE>
(1) Includes 675,000 shares which the underwriters have the option to purchase
to cover over-allotments, if any.
(2) Estimated solely for purposes of calculating the registration fee in
accordance with Rule 457(o) under the Securities Act, as amended.
(3) All of this amount has been previously paid.
THE REGISTRANT HEREBY AMENDS THIS REGISTRATION STATEMENT ON SUCH DATE OR
DATES AS MAY BE NECESSARY TO DELAY ITS EFFECTIVE DATE UNTIL THE REGISTRANT SHALL
FILE A FURTHER AMENDMENT WHICH SPECIFICALLY STATES THAT THIS REGISTRATION
STATEMENT SHALL THEREAFTER BECOME EFFECTIVE IN ACCORDANCE WITH SECTION 8(a) OF
THE SECURITIES ACT OF 1933 OR UNTIL THE REGISTRATION STATEMENT SHALL BECOME
EFFECTIVE ON SUCH DATE AS THE COMMISSION, ACTING PURSUANT TO SECTION 8(a), MAY
DETERMINE.
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<PAGE> 2
July 20, 1999
VIA EDGAR, FACSIMILE & EXPRESS MAIL
Mr. H. Roger Schwall
Mr. John Penn
Mr. Brad Skinner
Securities and Exchange Commission
Division of Corporation Finance
450 Fifth Street, N.W., Mail Stop 4-5
Washington, D.C. 20549
Re: N2H2, Inc.--Registration Statement on Form S-1
Filed May 14, 1999--File No. 333-78495
Dear Messrs. Schwall, Penn and Skinner:
This letter responds to the comments of the Staff set forth in your letter dated
July 16, 1999, relating to Amendment No. 2 to the Registration Statement on Form
S-1 for the sale of common stock of N2H2, Inc., filed with the Securities and
Exchange Commission on July 7, 1999 (File No. 333-78495). Responses that involve
textual changes to the Registration Statement are set forth in Amendment No. 3
to the Registration Statement, a copy of which will be delivered to you Tuesday,
July 20, 1999, and will be marked to show changes from Amendment No. 2 to the
Registration Statement. Amendment No. 3 is being filed with the Commission via
EDGAR today.
For your information, page references in this response letter are to Amendment
No. 3. N2H2's responses are set forth below and are numbered to correlate to the
paragraphs of your letter dated July 16, 1999.
RESPONSE TO COMMENT NO. 1
The chart on page 55 has been revised as per your request.
<PAGE> 3
Mr. H. Roger Schwall
Mr. John Penn
Mr. Brad Skinner
July 20, 1999
Page 2
RESPONSE TO COMMENT NO. 2
The embedded lists of text on pages 13 and 14 under "We Are Involved in
Intellectual Property Disputes and Cannot Predict the Likelihood or Impact of an
Unfavorable Outcome" and on page 50 under "Business--Legal Matters" have been
broken out into bullet point format.
RESPONSE TO COMMENT NO. 3
Language has been added under "Business--Legal Matters" on page 50 to the
discussion of the Spyglass, Inc. complaint stating that: "Since the lawsuit was
recently filed and discovery has not yet commenced, we are not presently able to
estimate the likelihood of an adverse result or the range of possible loss
relating to this matter."
RESPONSE TO COMMENT NO. 4
As indicated in discussions with James Allegretto and Brad Skinner on July 19,
1999, on a prospective basis and assuming continuance of the existing
contractual terms relative to server delivery, N2H2 will recognize revenue using
the installation date of the servers, instead of the shipment date, in
accordance with GAAP. Note 2 to N2H2's financial statements appearing on page
F-7 has been revised to state that "installation revenues are recognized when
the server is installed by the end user or a reseller. . . ." N2H2 has analyzed
the impact on revenues recognized using the installation date of the server
instead of the shipment date and determined that revenues recorded in fiscal
year 1998 were overstated by approximately $30,200 using the shipment date.
Revenues recorded for the six months ended March 31, 1999 were understated by
approximately $14,600 using the shipment date. The impacts of approximately
(0.98)% and 0.56% of total revenues, respectively, are considered immaterial for
adjustment in the respective financial statements.
RESPONSE TO COMMENT NO. 5
As we discussed with James Allegretto and Brad Skinner on July 19, 1999, the
warrants issued to The Segale Group in April 1999 in connection with the Loan
Conversion transaction are not exercisable until the occurrence of a specified
"Trigger Point." In fact, N2H2 expected the "End Point" to precede the Trigger
Point, thereby precluding the warrant from ever being exercisable. As provided
in Section 1.1 of the warrants:
The "TRIGGER POINT" shall occur upon the earlier of (a) [a merger or
business combination] and (b) the closing of an initial public offering
of the Company's equity securities in which the Segale Group or its
transferees is unable for whatever reason to sell in the aggregate at
least $500,000 of Common Stock of the Company. . . .
<PAGE> 4
Mr. H. Roger Schwall
Mr. John Penn
Mr. Brad Skinner
July 20, 1999
Page 3
In contrast, the "End Point" is defined as follows:
The "END POINT" shall occur upon the earlier of (a) December 31, 2003
and (b) the closing of an initial public offering of the Company's
equity securities in which the Segale Group, or its transferees, are
able to sell (at their discretion) up to $500,000 of Common Stock of the
Company held by it pursuant to the provisions of the Registration Rights
Agreement. . . .
EITF 96-18 states that equity issued with contingent terms "should be measured
using the stock price and other measurement assumptions as of the date on which
the quantity or terms of the equity instruments are no longer contingent on
satisfaction of the terms of the exchange transaction (that is, the vesting
date.)" The terms of the EITF 96-18 were not satisfied as of the issuance date
of the warrants. Accordingly, the warrants were not fair valued at the time of
issuance. At present, the Trigger Point has not occurred and the warrants remain
unexercisable. Under the pending offering, The Segale Group is being offered the
opportunity to sell $500,000 of N2H2 common stock. Accordingly, the warrant
rights will expire unvested before satisfaction of the contingent terms can
occur. Therefore, the warrants have not been fair valued consistent with EITF
98-16 and should be given no additional recognition in N2H2's financial
statements.
RESPONSE TO COMMENT NO. 6
The prior language on the back cover referenced in your comment no. 6 has been
deleted.
RESPONSE TO COMMENT NO. 7
N2H2 relied upon the exemption from registration under Section 4(2) of the
Securities Act of 1933 and Rule 506 of Regulation D. N2H2 filed a Form D with
the Commission on May 25, 1999.
Of the 66 different purchasers in the May 11, 1999 private equity financing, 51
of the 66 investors were newly introduced to N2H2. The remaining 15 investors
were pre-existing shareholders, having purchased common stock in December 1998
and January 1999. None of the investors were employees or affiliates of
employees of N2H2.
Additional information regarding the May 1999 investors is as follows:
o 31 of the investors were introduced to N2H2 by Cruttenden Roth,
acting as an investment adviser for N2H2.
<PAGE> 5
Mr. H. Roger Schwall
Mr. John Penn
Mr. Brad Skinner
July 20, 1999
Page 4
o 21 of the investors have personal or business relationships with
members of N2H2 management, and of those, only one was an
existing shareholder prior to the May 1999 offering. Of these,
- Three were introduced by the Madrona Group, LLP, with
whom N2H2 entered into a Management Services Agreement
in 1997,
- One was referred by Washington Partners, N2H2's real
estate advisor,
- Six were referred through Imperial Bank, with whom N2H2
maintains a term loan and revolving line of credit,
- One is a personal friend of the N2H2's Chief Executive
Officer,
- Two were introduced by N2H2's legal counsel,
- Four were referred through Volpe Brown Whelan & Co. and
- Four were referred through local Seattle venture capital
funds (WR Hambrecht, Kirlan Venture Partners and Summit
Capital) with whom N2H2 had been in contact regarding
potential private financings.
If you have any further questions, please contact the undersigned at (206)
223-7401 or Michael E. Morgan of this office at (206) 223-7013.
Very truly yours,
LANE POWELL SPEARS LUBERSKY LLP
/s/ ERIC SCOTT CARNELL
--------------------------------
Eric Scott Carnell
Enclosures
cc (w/enc): N2H2, Inc.
CIBC World Markets Corp.
U.S. Bancorp Piper Jaffray Inc.
Cooley Godward LLP
PricewaterhouseCoopers LLP
<PAGE> 6
SUBJECT TO COMPLETION, DATED JULY 20, 1999
THE INFORMATION CONTAINED IN THIS PRELIMINARY PROSPECTUS IS NOT COMPLETE AND MAY
BE CHANGED. THESE SECURITIES MAY NOT BE SOLD UNTIL THE REGISTRATION STATEMENT
FILED WITH THE SECURITIES AND EXCHANGE COMMISSION IS EFFECTIVE. THIS PRELIMINARY
PROSPECTUS IS NOT AN OFFER TO SELL AND IT IS NOT SOLICITING AN OFFER TO BUY
THESE SECURITIES IN ANY STATE WHERE THE OFFER OR SALE IS NOT PERMITTED.
4,500,000 SHARES
[N2H2 LOGO]
COMMON STOCK
$ PER SHARE
- --------------------------------------------------------------------------------
This is the initial public offering of N2H2, Inc. We are offering 4,450,000
shares, and shareholders identified at page 59 of this prospectus are offering
50,000 shares.
The estimated initial public offering price will be between $10.00 and $12.00
per share. The market price of the shares after the offering may be higher or
lower than the offering price.
We have applied to include the common stock on the Nasdaq National Market under
the symbol "NTWO."
INVESTING IN THE COMMON STOCK INVOLVES RISKS. SEE "RISK FACTORS" BEGINNING ON
PAGE 7.
<TABLE>
<CAPTION>
PER SHARE TOTAL
--------- -------
<S> <C> <C>
Price to the public......................................... $ $
Underwriting discounts......................................
Proceeds to N2H2, Inc., before expenses ....................
Proceeds to the selling shareholders, before expenses.......
</TABLE>
N2H2 has granted an over-allotment option to the underwriters. Under this
option, the underwriters may elect to purchase a maximum of 675,000 additional
shares from N2H2 within 30 days from the date of this prospectus to cover
over-allotments.
- --------------------------------------------------------------------------------
NEITHER THE SECURITIES AND EXCHANGE COMMISSION NOR ANY STATE SECURITIES
COMMISSION HAS APPROVED OR DISAPPROVED OF THESE SECURITIES OR PASSED UPON THE
ADEQUACY OR ACCURACY OF THIS PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY IS A
CRIMINAL OFFENSE.
CIBC WORLD MARKETS
U.S. BANCORP PIPER JAFFRAY
The date of this prospectus is , 1999.
<PAGE> 7
[PHOTOS]
MILLIONS OF USERS TRUST N2H2
to make their Internet safe and productive. We enable schools, families,
businesses and other organizations to experience the best of the Web, without
bombs, pornography, hate or other content that seriously concerns teachers,
parents and employers.
[PHOTOS]
<PAGE> 8
[BESS(R) LOGO]
[SAFETY]
[PHOTOS]
BESS INTERNET FILTERING SERVICE
We delivered 348,700,000 filtered Web pages in May 1999.
BESS PATROLS THE INTERNET
Using proprietary technologies, automated Web searching identifies potentially
objectionable content.
HUMAN REVIEW MAKES A DIFFERENCE
Our trained review staff carefully evaluates suspect Web sites to accurately
place Internet content into 32 categories.
SCHOOL
WORLDWIDE SERVER NETWORK
Entire Bess database resides on each server, automatically updated daily with
new entries. Users choose which categories are filtered, and receive Web pages
from their local server.
BESS BUILDS SEARCHOPOLIS TRAFFIC
The "Redirect" page appears when users attempt to access blocked Web sites,
providing direct access to Searchopolis.
LIBRARY
HOME
BUSINESS
GROWING WITH THE INTERNET
6,000 schools, 190 ISPs and increasing numbers of libraries and businesses now
use Bess filtering services.
BESS LEAVES AN IMPRESSION
A proprietary "trailer" appears at the bottom of each Web page, providing user
options and sponsorship opportunities.
[PHOTOS]
<PAGE> 9
[SEARCHOPOLIS(SM) LOGO]
[GRAPHICS]
FILTERED SEARCH ENGINE & EDUCATION PORTAL
PUTTING THE INTERNET TO WORK AT SCHOOL AND AT HOME
Searchopolis offers schools and families powerful filtered search, educational
resources and compelling communications tools, making the Internet more
effective in the classroom and facilitating parental involvement.
GRADECHECKER
Provides students, parents and teachers Web-based access to grades, assignments
and other classroom information.
COMMUNITY-BUILDING TOOLS
Searchopolis will offer Web-based tools such as e-mail, chat and a Virtual
Locker to provide students controlled access to people and projects from school
or from home.
CLEAN SEARCH RESULTS
Unlike most conventional search engines, a search for "teenage jobs" using
Searchopolis does not provide links to pornography sites.
SEARCH
E-MAIL
VIRTUAL LOCKER
CALENDARS
<PAGE> 10
WITH N2H2'S INTELLIGENT FILTERING TECHNOLOGY, SCHOOLS, FAMILIES, LIBRARIES AND
BUSINESSES ARE EMPOWERED TO CHOOSE AND TO ACCESS THE INTERNET THEY WANT. OUR
TECHNOLOGY AND SERVICE CATALOGS INTERNET CONTENT THROUGH HUMAN REVIEW AND
AUTOMATED SEARCH TECHNOLOGIES. THIS TECHNOLOGY IS OUR CORE COMPETENCY, AND
PRODUCTS SUCH AS CUSTOMIZABLE SEARCH ENGINES AND PORTAL COMMUNITIES WILL
PROVIDE A FOUNDATION FOR A NEW INTERNET. YOUR INTERNET.
CUSTOMER AND SERVER LOCATIONS
[MAPS]
HAWAII
UNITED STATES, CANADA & MEXICO
SOUTH AMERICA
AUSTRALIA
EUROPE
Over 5 million students, families and other organizations in 8 different
countries currently use the Bess Internet Filtering Service.
<PAGE> 11
[PHOTO]
BESS INTERNET FILTERING SERVICE BY N2H2
[N2H2 LOGO]
<PAGE> 12
[N2H2 LOGO]
<PAGE> 13
TABLE OF CONTENTS
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Prospectus Summary.......................................... 3
Risk Factors................................................ 7
Forward-Looking Statements.................................. 18
Use of Proceeds............................................. 19
Dividend Policy............................................. 19
Capitalization.............................................. 20
Dilution.................................................... 21
Selected Financial Data..................................... 22
Management's Discussion and Analysis of Financial Condition
and Results of Operations................................. 24
Business.................................................... 34
Management.................................................. 52
Principal and Selling Shareholders.......................... 59
Certain Transactions........................................ 61
Description of Capital Stock................................ 64
Shares Eligible for Future Sale............................. 67
Underwriting................................................ 69
Legal Matters............................................... 71
Experts..................................................... 71
Where You Can Find More Information......................... 71
Index to Financial Statements............................... F-1
</TABLE>
------------------------------------
INFORMATION CONTAINED ON N2H2'S WEBSITE DOES NOT CONSTITUTE PART OF THIS
PROSPECTUS.
N2H2(R) and Bess(R) are registered United States trademarks of our company. This
prospectus also contains other product names, trade names and trademarks that
belong to us or to other organizations.
<PAGE> 14
PROSPECTUS SUMMARY
This summary highlights information contained in other parts of this prospectus.
It is not complete and may not contain all of the information that you should
consider before investing in the common stock. You should read this entire
prospectus carefully, including the section entitled "Risk Factors" and the
financial statements and related notes to those statements included in this
prospectus.
N2H2, INC.
OUR BUSINESS
N2H2 is a leading provider of internet content filtering services to schools. We
also provide these services to homes through internet service providers as well
as to corporations and organizations. We were the first company to offer a
server-based internet filtering solution for a customer's computer network. With
Bess, our flagship product, we currently provide filtering services to
approximately 7.3 million students in approximately 8,000 schools in the United
States and Canada. Our customers include the statewide networks serving most of
the public schools in Ohio, Tennessee, Maine, Oklahoma and Wisconsin, as well as
school systems in areas such as Los Angeles County, Baltimore, Boston, Calgary,
Seattle, Stockton and Tampa.
In May 1999, students and teachers accessed approximately 349 million Web pages
through Bess. To better serve the needs of our existing and potential school
customers, we recently introduced Searchopolis as an educational internet
portal. As a portal, Searchopolis is specifically designed to maximize the
educational potential of the internet by aggregating educational content in one
place. It also links to other relevant Websites and provides safe access to
internet content using our award winning filtering search technology. We are
developing additional specialized communication tools and services and plan to
integrate them into Searchopolis, further enhancing its capabilities as the
portal of choice for the community of students, teachers, parents and
administrators. Searchopolis is available at www.searchopolis.com to any
internet user who wants access to a safe, educationally enriched internet
portal.
We are also actively extending our filtering services to corporations and other
organizations and, through approximately 190 internet service providers, into an
increasing number of homes. We develop, market and support internet filtering
solutions that enable businesses to increase productivity by limiting the
content that employees can access on the internet without blocking material that
is useful for their jobs. We recently entered into agreements with Computer
Sciences Corporation to provide it with company wide filtering of employee
internet use, with GTE Interactive to market internet filtering to hotels for
guest rooms and with the Mormon Church to provide internet filtering services to
its Website. Through our current internet service provider relationships, our
filtering services are available to over 150,000 homes.
Our filtering services enable our school, business and other customers to limit
access to the internet by allowing them to select from among 32 content
categories ranging from pornography, hate and bomb construction to gambling and
games. The key benefits of our services include:
- automated identification of potentially unsuitable Websites backed by human
review to accurately place internet content into our database of 32
categories,
- proprietary tools which enable customers to tailor their filtering criteria
to meet their specific needs,
- minimal customer effort required for installation and maintenance,
- server-based filtering that is difficult to bypass and
- daily electronic updating of the filtering database.
OUR MARKET OPPORTUNITY
We believe the school, home and corporate markets, both domestic and
international, present us with significant opportunities. According to Quality
Education Data, in the United States there are approximately 47 million students
in public schools grades K-12 within 16,000 school districts and
3
<PAGE> 15
approximately 5 million private school K-12. The Annenberg Public Policy Center
estimates that 60% of United States households with children aged 8 to 17 have
computers and 61% of those are connected to the internet. International Data
Corporation estimates that medium and large businesses will account for 49
million internet users worldwide by the year 2000. Without an effective internet
content filtering system in place, educators and parents have to choose between
undesirable alternatives: prohibiting internet access altogether or closely
supervising each student's use of the internet. Corporations and other
organizations also face issues associated with unrestricted on-the-job access to
the internet, including productivity losses caused by employees surfing the
internet for personal reasons during work hours as well as potential liability
concerns.
OUR OBJECTIVE
Our objective is to expand our presence in the school, home and corporate
markets both domestically and internationally. As part of this objective, we
intend to make Searchopolis the leading education focused Web portal for K-12
students. Achievement of our objective is subject to a number of uncertainties
and risks, many of which are outside our control. For more information about
these risks and uncertainties, please see "Risk Factors" and "Forward-Looking
Statements."
Our principal executive offices are located at 900 Fourth Avenue, Suite 3400,
Seattle, Washington 98164, our telephone number is (206) 336-1501 and our
Website address is www.n2h2.com.
4
<PAGE> 16
THE OFFERING
<TABLE>
<S> <C>
Common stock offered by N2H2................................ 4,450,000 shares
Common stock offered by the selling shareholders............ 50,000 shares
Common stock to be outstanding after this offering (1)...... 20,097,607 shares
Use of proceeds............................................. For working capital, sales and
marketing, research and
development, capital
expenditures and general
corporate purposes.
Proposed Nasdaq National Market Symbol...................... NTWO
</TABLE>
- -------------------------
(1) The number of shares outstanding is based on shares outstanding as of July
7, 1999 and excludes:
- 2,799,749 shares of common stock subject to options outstanding, with a
weighted average exercise price of $1.61 per share,
- 103,127 additional shares of common stock that could be issued under our 1997
Stock Option Plan, 1999 Stock Option Plan and 1999 Nonemployee Director Stock
Option Plan,
- 460,420 shares of common stock that could be issued upon exercise of
outstanding warrants, with an exercise price of $3.14 per share and
- 93,000 shares of common stock that could be issued upon exercise of warrants,
with an exercise price of $0.004 per share, which will be cancelled upon the
completion of this offering.
All share information contained in this prospectus gives effect to a
five-for-two stock split anticipated to be completed before the closing of this
offering.
Unless otherwise stated, all information contained in this prospectus assumes no
exercise of the over-allotment option granted to the underwriters.
The underwriters are offering the shares subject to various conditions and may
reject all or part of any order. The shares should be ready for delivery on or
about , 1999.
See "Capitalization," "Management -- Stock Option Plans" and "Description of
Capital Stock" for a more complete discussion regarding the outstanding shares
of N2H2 common stock and options and warrants to purchase N2H2 common stock and
other related matters.
5
<PAGE> 17
SUMMARY FINANCIAL DATA
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
SIX MONTHS ENDED
FISCAL YEAR ENDED SEPTEMBER 30, MARCH 31,
-------------------------------------- -------------------------
1996 1997 1998 1998 1999
---------- ---------- ---------- ---------- -----------
(UNAUDITED)
<S> <C> <C> <C> <C> <C>
STATEMENT OF OPERATIONS
DATA:
Revenues.................... $ 108 $ 1,118 $ 3,078 $ 1,298 $ 2,605
Gross profit................ 30 816 1,925 845 1,351
Operating loss.............. (817) (762) (2,310) (569) (1,768)
Net loss.................... (827) (881) (2,597) (679) (2,015)
Basic and diluted net loss
per share (1)............. $ (0.11) $ (0.10) $ (0.30) $ (0.08) $ (0.19)
Basic and diluted weighted
average shares
outstanding............... 7,316,858 8,389,878 8,687,435 8,686,411 10,758,005
</TABLE>
<TABLE>
<CAPTION>
AS OF MARCH 31, 1999,
---------------------------------------------
ACTUAL PRO FORMA(2) AS ADJUSTED(3)
----------- ------------ --------------
BALANCE SHEET DATA: (UNAUDITED)
<S> <C> <C> <C>
Cash................................................. $ 1,384 $ 9,184 $54,078
Working capital (deficit)............................ (3,051) 6,695 51,589
Property and equipment, net.......................... 2,045 2,045 2,045
Total assets......................................... 4,285 12,085 56,979
Long-term obligations, excluding current portion
(4)................................................ 775 775 775
Total shareholders' equity (deficit)................. (1,836) 7,910 52,804
</TABLE>
- ---------------------------
(1) See Note 10 of the Notes to Financial Statements for an explanation of the
determination of the number of shares used in computing the share data.
(2) Pro forma reflects the sale of 2,705,648 shares of common stock at a per
share price of $3.70 per share on May 11, 1999 and the application of the
net proceeds from that sale.
(3) As adjusted to reflect:
- the sale by us of 4,450,000 shares of common stock at an assumed initial
offering price of $11.00 per share,
- the application of the estimated net proceeds after deducting estimated
underwriting discounts and commissions and
- our estimated offering expenses.
For additional information on these matters, please see "Use of Proceeds"
and "Capitalization."
(4) Includes capital lease obligations.
6
<PAGE> 18
RISK FACTORS
You should carefully consider the following risk factors and all other
information contained in this prospectus before purchasing our common stock.
Investing in our common stock involves a high degree of risk. The risks
described below are not the only ones that we may face. Additional risks that
are not yet identified or that we currently think are immaterial may materially
adversely affect our business and financial condition in the future. Any of the
following risks could seriously harm our business, financial condition and
operating results and could result in a complete loss of your investment.
WE HAVE A LIMITED OPERATING HISTORY AND A HISTORY OF LOSSES.
We have a limited operating history. Risks and uncertainties inherent in an
investment in N2H2 include, but are not limited to the following:
- we are an internet company in the early stages of development,
- our limited history makes evaluation of our prospects difficult,
- our market is rapidly evolving and highly competitive and
- we have incurred net losses in each quarter since we incorporated in 1995.
We incurred net losses of $827,000 for 1996, $881,000 for 1997 and $2.6 million
for 1998. From inception through March 31, 1999, we had incurred operating
losses of $6.4 million. We anticipate that we will continue to incur net losses
for the foreseeable future.
WE INTEND TO SUBSTANTIALLY INCREASE OUR OPERATING EXPENSES, AND OUR FUTURE
OPERATING RESULTS ARE UNCERTAIN.
We intend to incur increased operating expenses before we receive any revenues
from these expenses. Increased operating expenses in 1999 and beyond will
include:
- sales and marketing costs, including expanding our direct sales force and
further developing our advertising sales force, indirect sales channels and
international sales presence,
- research and development costs, primarily through the hiring of additional
engineers and other technical staff,
- increased depreciation expenses related to installing additional servers in
customers' networks,
- increased depreciation expenses for equipment supporting Searchopolis and
Searchopolis communication tools,
- implementing new and upgraded operational and financial systems, procedures
and controls and hiring additional personnel,
- assuming the responsibilities of being a public company and
- expanding our customer support and service operations.
We will need to significantly increase our revenues to achieve and maintain
profitability. Although our revenues have grown in recent quarters, we may not
be able to continue this growth or achieve or maintain profitability. We may
also fail to accurately estimate and assess increased operating expense
requirements as we grow. If we fail to achieve and maintain profitability, our
future capital raising efforts and planned growth of our business would be
seriously harmed.
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WE PLAN TO OFFER SCHOOLS ALTERNATE FEE STRUCTURES, AND OUR FUTURE REVENUES FROM
THESE FEES ARE UNCERTAIN.
We plan to launch a new, untested fee structure. Our alternate fee structure for
school customers will reduce or eliminate subscription fees which have
traditionally represented a significant portion of our revenues. We have had
insignificant advertising revenues to date, and we cannot assure you that
customers will accept our alternate fee structure. Even if they accept the
alternate fee structure, we cannot assure you that we will receive enough
advertising revenues to make up for lost subscription fees. At present we do not
have any contracts in place directly with advertisers.
Up to now, we have derived substantially all of our revenues through a
combination of subscription and installation fees for our filtering services.
Our subscription revenues were $26,000 for 1996, $548,000 for 1997 and $1.7
million for 1998 and our installation revenues were $82,000 for 1996, $570,000
for 1997 and $1.4 million for 1998. As a percentage of total revenues,
subscription revenues represented 24% for 1996, 49% for 1997 and 56% for 1998.
THE MARKET FOR INTERNET ADVERTISING IS UNCERTAIN.
We expect to obtain a substantial amount of our revenues from internet
advertising for the foreseeable future, but the demand and market acceptance for
internet advertising are uncertain. No accepted standard currently exists to
measure the effectiveness of internet advertising. Standard measurements may
need to be developed to support and promote the internet as a significant
advertising medium. Also, a number of different pricing methods are used to sell
advertising on the internet. We cannot predict which of those pricing methods,
if any, will emerge as the industry standard. Typically, internet advertising is
conducted through the use of "click-through" advertising banners. Recent studies
indicate that click-through rates have declined over the past year. Future
revenues and the growth of our business will be seriously harmed if the market
for internet advertising develops more slowly than expected or we are unable to
adapt to new forms of internet advertising.
WE ARE UNABLE TO PREDICT OUR ADVERTISING REVENUES.
We have received insignificant advertising revenues to date and cannot predict
our future advertising revenues. We expect our internet advertising revenues
will fluctuate significantly in the future as a result of a variety of factors,
many of which are outside our control. If we fail to obtain advertising or
sponsorship contracts, or if our contracts are cancelled or renewed at lower
rates, our business, financial condition and operating results will be seriously
harmed. These factors include:
- our ability to provide content attractive to our target audiences,
- the development of our brand,
- the level of user traffic on Bess and Searchopolis,
- demand for internet advertising,
- the use of internet advertising blocking software by customers and end users,
- our ability to attract and retain advertisers,
- the mix of types of advertising we sell and
- the timing of initial set-up, engineering or development fees that may be
paid in connection with larger advertising arrangements.
ADVERTISING IN SCHOOLS IS CONTROVERSIAL.
Advertising in schools is controversial and may generate negative publicity
toward us and our sponsors. Some parents, teachers and public officials believe
that advertisements in schools compromise the integrity of the educational
environment. They argue that advertisements distract from learning and that
classroom
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audiences are overly susceptible to marketing and advertising campaigns. We
screen the advertisements generated through our contract with 24/7 Media which
appear on Bess and Searchopolis in order to limit credit card and other types of
advertising which we believe are inappropriate for classrooms. However, there
can be no guarantee that we will succeed in preventing access to undesirable
advertisements. For example, we cannot screen advertisements contained within
Web pages retrieved through Bess or Searchopolis. The appearance of
controversial advertisements through our services may diminish sponsors'
interest in advertising with N2H2 and may result in significant negative
publicity toward us among parents, teachers and students.
Our alternate fee structure for schools is based upon offering schools the
choice between paying our current subscription fees or receiving our services at
reduced rates or without charge in exchange for allowing us to display
advertisements. It is possible that parents, teachers, students or the public at
large will object to internet advertising. If they do, the resulting negative
publicity could limit our ability to offer advertising-based pricing in the
future, which would seriously limit the growth of our business and harm our
financial condition and results of operations.
OUR EXPANSION INTO THE INTERNET PORTAL MARKET INVOLVES A NUMBER OF RISKS.
Our future revenue growth is greatly dependent upon the success and market
acceptance of our current development efforts to enhance Searchopolis and our
ability to derive advertising or other revenue from Searchopolis. In addition,
we plan to market our enhanced version of Searchopolis to our existing and
potential filtering service customers. Existing and potential customers may not
use Searchopolis for a number of reasons, including an absence of desired
capabilities or content or the failure of Searchopolis to be competitive with
other internet searching services. Also, we must overcome significant obstacles
in our expansion into the internet portal market, including:
- competitors such as Yahoo! Inc., America Online, Inc., Netscape
Communications Corporation, Lycos, Inc., Excite, Inc., Wired Digital, Inc.
(HotBot), Infoseek Corporation and others that have more experience, better
name recognition and greater resources,
- the limited experience of our sales personnel in the internet portal market
and
- our limited experience in obtaining revenues from developing and marketing
internet filtering search technology.
OUR QUARTERLY FINANCIAL RESULTS FLUCTUATE AND MAY BE AFFECTED BY SEASONAL
VARIATIONS.
Our quarterly operating results have fluctuated significantly in the past and
will continue to fluctuate in the future. Operating results vary depending on a
number of factors, many of which are outside our control, including:
- our educational services customers typically budget and purchase goods and
services on a fiscal school year basis beginning in August of each year,
- user traffic on our school customer systems has historically been lower
during the summer and during year end vacation and holiday periods, and
advertising revenues may be less during these periods,
- we typically receive subscription payments in advance of the costs directly
associated with delivery of monthly services over the term of the 12 month
contract, making it difficult to associate costs with cash flows,
- quarterly cash flows from subscription payments are difficult to forecast
because the sales cycle, from initial evaluation to delivery of the services,
varies substantially between customers and
- as we expand our sales force, professional services personnel and research
and development staff, our operating expenses will continue to rise.
Due to the combination of these and other factors, quarter to quarter
comparisons of operating results are not meaningful or indicative of future
performance. Further, it is possible that in some future quarter or
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quarters our operating results will not meet or exceed the expectations of
public market analysts or investors. If that happens, or if adverse conditions
prevail or are perceived to prevail, either for our business or the market
generally, the market price of our common stock would be seriously harmed. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Selected Quarterly Operating Results" for a discussion and
comparison of our quarterly operating results.
OUR SUCCESS DEPENDS ON CONTINUED MARKET ACCEPTANCE AND OPERATION OF OUR INTERNET
FILTERING SERVICES.
If we are unable to continue to solve our customers' internet content filtering
problems, we will experience diminished revenues and the growth of our business
will be impaired. We currently receive, and expect to continue to receive, a
substantial portion of our revenues from our internet filtering services. Our
future financial performance will depend, in part, upon the successful
development, introduction and customer acceptance of new and enhanced versions
of our internet filtering services. We cannot assure you that we will be
successful in upgrading and continuing to sell our internet filtering services
or that any new products or services that we may develop or acquire will achieve
market acceptance. Any failure to upgrade our services or products or to
maintain our market acceptance could seriously harm our business, financial
condition and results of operations.
OUR FILTERING CATEGORIZATIONS ARE SUBJECTIVE, AND WE MAY FAIL TO FILTER ALL
POTENTIALLY OBJECTIONABLE CONTENT.
We may not succeed in sufficiently filtering internet content to meet our
customers' expectations. We rely upon a combination of automated filtering
technology and human review to categorize Website content through our Bess
filtering services and on Searchopolis, our filtered Web portal. The total
number of Websites and partial Websites is growing rapidly. A partial Website is
a graphic image, text or other visual appearing as a part of a full Webscreen
display. We rely upon our staff of reviewers to place internet content into our
32 content categories. We cannot assure you that our filtering technologies will
successfully block all potentially objectionable internet content. Our
categorized database also may not contain substantially all of the material
available on the internet fitting into any one of our content categories. In
addition, our customers may not agree with our categorization determinations.
Our failure to effectively categorize and filter internet content according to
our customers' expectations would generate negative publicity which would impair
the growth of our business and our efforts to increase brand awareness.
OUR ABILITY TO MANAGE GROWTH IS UNPROVEN.
Our growth is likely to continue to place a significant strain on our
managerial, operational, financial and other resources. We have grown from 41
part and full time employees as of May 31, 1997, to 79 as of May 31, 1998 and to
154 as of May 31, 1999. Our future success will depend, in part, upon the
ability of our senior management to manage growth effectively. This will require
us to:
- implement additional management information systems,
- develop further our operating, administrative, financial and accounting
systems and controls,
- hire additional personnel and
- locate additional office space in the United States and internationally.
WE MAY FAIL TO COMPETE SUCCESSFULLY WITH OTHER PROVIDERS OF INTERNET FILTERING
SERVICES.
The market for our services and products is intensely competitive and rapidly
changing. Many of our competitors are larger and have substantially greater
resources than us. Our primary competition comes from keyword, Universal
Resource Locator and packet filtering software applications. These products are
significantly less expensive than our filtering services and can often be
downloaded for free over the internet.
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We compete directly with a number of internet content management firms,
including publishers and distributors of traditional media and general purpose
consumer online services such as America Online and Microsoft Network. Although
we believe the internet provides opportunities for more than one provider of
content filtering services similar to ours, one or more of our competitors may
eventually dominate the sector. Further, we have only recently begun to provide
these services, and competitors' products and services may achieve greater
market acceptance than ours.
We also compete for users and advertisers with virtually all Websites. Our
competitors for users and advertisers include:
- Web retrieval and other Web portal companies, such as Excite, Infoseek,
Lycos, Yahoo! and Netscape and
- Websites such as Disney.com, AOL.com and others that provide education and
family oriented content.
We also compete with television, radio, cable and print media for a share of
total advertising budgets.
Increased competition could result in price reductions, reduced profitability,
or loss of market share, any of which would seriously harm our business,
financial condition and results of operations.
WE WILL NEED TO ESTABLISH AND MAINTAIN STRATEGIC RELATIONSHIPS.
We depend on strategic relationships to offer services and products to a larger
customer base than can be reached through our direct sales efforts. We have a
strategic relationship with Inktomi for operating our filtering search
technology. We also have other strategic content and marketing relationships
with companies, including Looksmart Ltd., WinStar Communications, Inc., Fortres
Grand Corporation and Netwave Technologies, Inc. Our plans for developing our
international business rely on additional strategic relationships. We cannot
assure you that we will be able to maintain and expand our strategic
relationships or enter into new strategic relationships or that these new
relationships will be on commercially reasonable terms.
If we are unable to maintain and expand our existing strategic relationships or
enter into new strategic relationships, we will need to use substantially more
resources to develop, distribute, sell and market our services and products than
planned. We would also lose the customer introductions and co-marketing benefits
that we anticipate from such strategic relationships. Our success will depend
both on the success of the other parties to these relationships and on their
ability to market our services and products successfully. Most of these
companies have multiple strategic relationships, and we cannot assure you that
they will regard their relationships with us as significant for their own
businesses. If any of these firms fail to effectively promote our services or
products, our business, financial condition and results of operations will be
seriously harmed through decreased growth opportunities.
WE ARE DEPENDENT ON KEY INDIVIDUALS WHO MAY BE SUBJECT TO CONFLICTING DEMANDS.
Our success depends on the performance of our senior management, particularly
Peter H. Nickerson, our President, Chief Executive Officer and Chairman of the
Board, and Kevin E. Fink, our Chief Technology Officer. On May 10, 1999, we
entered into employment agreements with Mr. Nickerson and Mr. Fink, and we
subsequently entered into similar agreements with other members of senior
management. The term of Mr. Nickerson's agreement is two years, and Mr. Fink's
agreement is for an 18 month term. Both are renewable indefinitely. See
"Management -- Employment Agreements" for a more complete description of the
employment agreements. Mr. Nickerson is also a principal of Nickerson &
Associates, an econometric and data management consulting company, and he
performs consulting services for that firm that could impose conflicting demands
on his time.
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OUR SUCCESS DEPENDS ON OUR ABILITY TO ATTRACT AND RETAIN QUALIFIED AND
EXPERIENCED EMPLOYEES.
We face a significant risk from a loss of any member of our senior management
team or any key employee, particularly if they join or form a competitor. These
risks relate mainly to:
- the loss of such individual's skills and talent,
- the resulting loss of existing or potential customers or
- the unauthorized disclosure or use of our technical knowledge, practices,
procedures or customer lists.
Loss of a key employee could seriously harm our business, financial condition
and results of operations. We cannot assure you that in such an event we would
be able to recruit personnel to replace our senior management in a timely manner
and on acceptable terms.
We expect there will continue to be competition for experienced engineering,
sales and consulting personnel, particularly in the internet market. Many of the
companies we compete against for experienced personnel have greater resources
than us. Competition in the Seattle area for these personnel is particularly
intense, and we cannot assure you that we will be successful in attracting and
retaining qualified personnel. As a result, our growth could be limited due to
our lack of capacity to provide our services. We could also experience
deterioration in service levels or decreased customer satisfaction. Either of
these occurrences would seriously harm our business, financial condition and
results of operations through increased costs of doing business and decreased
demand for our services.
EXPANDING OUR INTERNATIONAL OPERATIONS EXPOSES US TO A NUMBER OF RISKS.
We currently have very limited international operations. Our installation and
subscription revenues from customers outside the United States, primarily in the
United Kingdom and Canada, represented approximately $84,000 in the fiscal year
ended September 30, 1998, and $144,000 for the six months ended March 31, 1999.
As a key component of our business strategy, we intend to expand our
international sales and support operations, and for that purpose we hired a
European operations director in June 1999. Our ability to expand our
international operations is subject to a number of risks, including:
- our ability to customize services for local markets and foreign languages,
- laws and business practices favoring local competitors,
- our dependence on local staff and vendors,
- compliance with multiple, conflicting and changing governmental laws and
regulations, including tax laws and regulations,
- longer sales cycles,
- possible delays or greater difficulty in accounts receivable collection,
- import and export restrictions and tariffs and
- uncertainties regarding transactions in foreign currencies.
Currently, we do not engage in or intend to engage in hedging. If we are unable
to successfully manage the risks associated with our international operations,
our international sales growth will be limited and our results of operations
will be seriously harmed.
OUR SERVICES MAY HAVE LIMITED INTEROPERABILITY AND MAY NOT KEEP PACE WITH RAPID
TECHNOLOGICAL CHANGES.
We may fail to develop filtering services compatible with future operating
systems, and we may not keep pace with technological advances. Our internet
services are designed to operate with a variety of hardware and software used by
our customers. Our school customers may use older operating systems, however,
requiring us to maintain multiple service platforms at increased cost to us. In
addition, we must
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continuously modify and enhance our services to keep pace with changes in
hardware, software, communication, browser and database technology.
Uncertainties about the timing and nature of vendors' new product announcements
or their introduction or modification of operating systems would require
increased research and development expenses. The failure of our services to
operate effectively across existing and future versions of hardware and software
used by customers would limit or reduce the market for our services, result in
customer dissatisfaction and seriously harm our business, financial condition
and results of operations.
WE HAVE LIMITED PROTECTION OF OUR INTELLECTUAL PROPERTY AND PROPRIETARY
TECHNOLOGY.
We may fail to adequately protect our intellectual property and proprietary
technology. Intellectual property is critical to our success, and we rely upon
trademark, copyright and trade secret laws in the United States and other
jurisdictions to protect our proprietary technology and brands. N2H2 and Bess
are registered United States trademarks. We have also applied to register
Searchopolis and Virtual Locker as trademarks. These trademark applications may
not be granted. In addition, any of our trademarks may be challenged by others
or invalidated through administrative process or litigation. None of our
technology is patented, and we have no patent applications pending. Our
proprietary search technology is protected by United States trade secret and
copyright laws. We own and operate the servers that provide our filtering
services. We protect our proprietary rights through the use of intellectual
property agreements with employees and consultants covering confidentiality,
nondisclosure and assignment of invention matters. Some of our former employees
and consultants who may have had access to our proprietary information have not
entered into these intellectual property agreements, although we believe that
all intellectual property that is material to our business is covered by signed
agreements. If we are wrong in this assessment, former employees could use our
proprietary technology without our having an effective remedy, and our business
would be seriously damaged.
WE ARE SUBJECT TO RISKS OF INFRINGEMENT.
Trademark, copyright and trade secret protection may not be available to us in
every country in which our services are available. The laws of some foreign
countries may not be as protective of intellectual property rights as United
States laws, and mechanisms for enforcement of intellectual property rights may
be inadequate. Despite our efforts to protect our proprietary rights,
unauthorized parties may obtain, copy and use our proprietary technology. We
expect that it will become more difficult to monitor use of our services as we
increase our international presence. We cannot assure you that our means of
protecting our proprietary technology and brands will be adequate or that our
competitors will not independently develop similar technology.
WE ARE INVOLVED IN INTELLECTUAL PROPERTY DISPUTES AND CANNOT PREDICT THE
LIKELIHOOD OR IMPACT OF AN UNFAVORABLE OUTCOME.
We are a defendant in two lawsuits recently filed in California. One lawsuit,
filed by Spyglass, Inc. in June 1999, alleges patent infringement claims. The
other lawsuit, filed by NextGen Development Corporation in May 1999, alleges
misuse of proprietary information. We expect that as competition in the market
for internet filtering increases and as the number of patents continues to
increase, the potential for intellectual property claims against us will also
increase. Prolonged litigation against us concerning alleged infringement would
likely result in significant expense to us and divert the efforts of our
management and development personnel, even if we are successful in that
litigation. In the event of an adverse result, we could be required to do one or
more of the following:
- pay substantial damages, including treble damages,
- permanently cease use of any infringing technology,
- obtain a license for the technology or expend significant resources to
develop noninfringing technology and
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- attempt to redesign our filtering services to avoid the infringement or
to develop noninfringing technology.
Any limitation on our ability to market our services or products or any
incurrence of substantial costs and delays associated with redesigning our
services or products would seriously harm our business, financial condition and
results of operations. See "Business -- Legal Proceedings" for further
discussion of the two lawsuits filed against us.
THE YEAR 2000 MAY RESULT IN UNEXPECTED COMPUTER PROBLEMS.
We may face exposure and risk if the systems on which we depend to conduct our
operations are not year 2000 compliant. The principal year 2000 risks we face
include:
- a failure of the systems we use to run our business,
- a failure of systems and products used by our vendors or
- an extensive breakdown of the internet and related loss of internet traffic
due to telecommunications, energy or other infrastructure failure.
A failure in any of these areas could temporarily shut down our operations and
seriously harm our business. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations -- The Year 2000" for additional
discussion of how we have addressed Year 2000 compliance issues.
OUR SERVICES CREATE RISKS OF POTENTIAL NEGATIVE PUBLICITY AND LEGAL LIABILITY.
Because customers rely on our services for providing a content safe internet
environment, any significant defects or errors in our services or products may
result in negative publicity or legal claims. This negative publicity or any of
these legal claims could seriously harm our business, financial condition and
results of operations. In addition, our ability to maintain a log of internet
data retrieval requests and the workstations from which they originated may
result in negative publicity or claims based on potential privacy violations.
Although our agreements with customers typically contain provisions designed to
limit our exposure to potential legal liability, these limitation of liability
provisions may not be completely effective. We have not experienced any
liability claims to date, but we cannot assure you that we will not face this
type of claim in the future. We maintain errors and omissions insurance, but we
cannot assure you that this insurance coverage will adequately cover us for any
claims.
OUR SYSTEMS MAY BE VULNERABLE TO SECURITY RISKS OR SERVICE DISRUPTIONS THAT
COULD HARM OUR BUSINESS.
Our servers are vulnerable to physical or electronic break-ins and service
disruptions, which could lead to interruptions, delays, loss of data or the
inability to process user requests. Such events could be very expensive to
remedy and could damage our reputation, discouraging existing and potential
customers from using our services. In the past we have experienced unsuccessful
attempts at electronic break-ins but we may experience break-ins in the future.
Any such events could substantially harm our business, financial condition and
results of operations.
In August 1998, we entered into an internet hosting agreement with Exodus
Communications, Inc., which will maintain some of our servers through August
1999, with automatic one year renewals. Our operations depend on Exodus's
ability to protect our systems against damage from fire, earthquake, power loss,
flood, telecommunications failures, vandalism and other malicious acts and
similar unexpected adverse events. Any major disruption in our services could
diminish revenues, decrease customer and user confidence in our services and
stunt the growth of our business.
WE MAY NOT BE ABLE TO DISTRIBUTE OUR SERVICES ABROAD DUE TO UNITED STATES EXPORT
LAWS.
The encryption technology contained in our services and products is subject to
United States export controls. Such export controls limit our ability to
distribute certain encrypted services and products outside
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of the United States. While we take precautions against unlawful exportation,
such exportation inadvertently may have occurred in the past or may occur from
time to time in the future, subjecting us to potential liability. Future
legislation or regulation may further limit the use of encryption technology
that we can include in our services and products. In addition, foreign
governments have import and domestic use laws and regulations that restrict the
types of permitted encryption software distributed in their countries. Such
regulations could alter the design, production, distribution and use of our
services and products.
THE FUTURE ROLE OF THE INTERNET IN EDUCATION IS UNCERTAIN.
The success of our services and products will depend, in large part, on the
continued broad use and acceptance of the internet as a source of information.
Schools, teachers and parents may cease to consider the internet a viable
research tool due to concerns over the potential exposure of students to
unsuitable material, even with filtering services such as ours, or because of
inadequate development of telecommunications and networking systems. The
internet could lose its viability due to delays in the development or adoption
of new standards and protocols to handle increased levels of internet activity
or due to increased governmental regulation. Cutbacks in technology funding
could also limit use of the internet in schools. If the necessary internet
infrastructure and complementary products are not developed on a timely basis,
or if school use of the internet experiences a significant decline, we may not
be successful in growing our business and our financial condition and results of
operations would be seriously harmed.
GOVERNMENT REGULATION AND LEGAL UNCERTAINTIES COULD ADD ADDITIONAL COSTS TO
DOING BUSINESS ON THE INTERNET.
Currently, few laws or regulations specifically govern communications or
commerce on the internet. Laws and regulations may be adopted in the future
regarding user privacy, pricing and the characteristics and quality of products
and services. For example, the Telecommunications Act of 1996 sought to prohibit
transmitting various types of information and content over the internet. Several
telecommunications companies have petitioned the Federal Communications
Commission to regulate internet service providers and online service providers
in a manner similar to long distance telephone carriers and to impose access
fees on those companies. This could increase the cost of transmitting data over
the internet.
WE MAY BE SUED FOR INFORMATION RETRIEVED FROM THE WEB.
We may be subject to claims relating to information available on our Website.
These types of claims have been brought, sometimes successfully, against online
services. We could also be subject to claims based upon the content that is
accessible from our Websites through links to other Websites or through content
and materials that may be posted by members in chat rooms or bulletin boards. We
also offer e-mail services, which may subject us to liabilities resulting from
unsolicited e-mail, lost or misdirected messages, illegal or fraudulent use of
e-mail or interruptions or delays in e-mail service. Our general commercial
liability insurance may not adequately protect us against these types of
potential claims.
THERE HAS BEEN NO PRIOR PUBLIC MARKET FOR OUR COMMON STOCK, AND WE EXPECT THAT
ITS PRICE WILL BE VOLATILE.
Prior to this offering, there has been no public market for our common stock,
and we cannot assure you that an active public market for our common stock will
develop or be sustained after this offering. The initial public offering price
of our common stock will be determined by negotiation among us and the
representatives of the several underwriters based upon a number of factors and
may not be indicative of the market price of our common stock following the
offering. The market price of our common stock is likely to be highly volatile
and could be subject to wide fluctuations in response to:
- quarterly variations in operating results,
- announcements of technological innovations or new services or products by us
or our competitors,
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- changes in financial estimates by securities analysts,
- our failure to meet or exceed analyst estimates and
- other events or factors, many of which are beyond our control.
In addition, the stock market has experienced significant price and volume
fluctuations that have particularly affected the market prices of equity
securities of many internet companies and that often have been unrelated or
disproportionate to the operating performance of these companies. A number of
publicly traded technology companies have current market prices below their
initial public offering price. Market fluctuations such as these may seriously
harm the market price of our common stock. In the past, following periods of
volatility in the marketplace for a company's securities, securities class
action litigation often has been instituted. We would incur substantial costs
and a diversion of management attention and resources resulting from such
litigation, which would seriously harm our business, financial condition and
results of operations.
AFTER THIS OFFERING, OUR OFFICERS, DIRECTORS AND SIGNIFICANT SHAREHOLDERS WILL
STILL HAVE VOTING CONTROL.
Upon completion of this offering, 59.8% of our outstanding common stock will be
beneficially owned by our directors, executive officers and each person or group
that we know owns more than 5% of our common stock, together with the
individuals or entities affiliated with them, assuming no exercise of
outstanding warrants or stock options. These shareholders, if acting together,
would be able to control substantially all matters requiring approval by our
shareholders, including the election of all directors and approval of
significant corporate transactions.
YOU WILL SUFFER IMMEDIATE AND SUBSTANTIAL DILUTION.
The initial public offering price per share will significantly exceed the net
tangible book value per share of our common stock. At the estimated initial
public offering price of $11.00 per share, dilution to new investors will be
$8.33 per share. Accordingly, if you purchase shares of our common stock in this
offering, you will suffer immediate and substantial dilution. See "Dilution" for
additional detail regarding the extent of your dilution.
OUR MANAGEMENT HAS BROAD DISCRETION OVER THE USE OF PROCEEDS FROM THIS OFFERING.
Although we intend to use the net proceeds of this offering for working capital
and general corporate purposes, our management can spend the proceeds in ways
with which our shareholders may not agree. The net proceeds may be used for
corporate purposes that do not increase our profitability or our market value.
Pending determination of how the proceeds will be used, the net proceeds of this
offering will be invested in short term, investment grade, interest bearing
securities that may lose value. See "Use of Proceeds" for a description of how
we intend to use the proceeds from this offering.
OUR FUTURE CAPITAL NEEDS ARE UNCERTAIN.
We may experience a material decrease in liquidity due to increased operating
expenses, unforeseen capital requirements or other events and uncertainties.
After that, we may need to raise additional funds, and additional financing may
not be available on favorable terms, if at all. Further, if we issue additional
equity securities, shareholders may experience dilution, and the new equity
securities may have rights, preferences or privileges senior to those of
existing holders of our common stock. If we cannot raise funds on acceptable
terms, we may not be able to develop or enhance our services, take advantage of
future opportunities or respond to competitive pressures or unanticipated
requirements. This may seriously harm our business and results of operations.
See "Use of Proceeds," "Dilution" and "Management's Discussion and Analysis of
Financial Condition and Results of Operations -- Liquidity and Capital
Resources" for descriptions of our historic and anticipated capital needs.
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WE HAVE IMPLEMENTED ANTI-TAKEOVER PROVISIONS.
Some provisions of our restated articles of incorporation and amended bylaws, as
well as provisions of Washington law, make it more difficult for a third party
to acquire us, even if doing so would be beneficial to our shareholders. See
"Description of Capital Stock -- Anti-takeover Effects of Provisions of Our
Restated Articles, Amended Bylaws and Washington Law" for a description of when
and how these provisions apply.
SUBSTANTIAL SALES OF SHARES MAY IMPACT THE MARKET PRICE OF OUR COMMON STOCK.
Sales of a substantial number of shares of common stock after the offering could
cause the market price of our common stock to fall. Such sales could make it
more difficult for us to raise capital through the sale of additional equity
securities. After completion of this offering, we will have 21,286,299 shares of
common stock outstanding or subject to currently exercisable options or warrants
or 21,961,299 shares if we issue shares upon exercise of the underwriters'
over-allotment option. Most of our shareholders, option holders and warrant
holders are limited by lock-up agreements restricting their ability to sell
their N2H2 common stock. They cannot sell or otherwise dispose of shares of our
common stock for a period of 180 days after the date of this prospectus without
the written consent of CIBC World Markets Corp. 15,460,965 shares may be
eligible for sale when the lock-up agreements expire. See "Shares Eligible for
Future Sale" for further detail regarding the number of shares which may be sold
and restrictions on those sales.
WE DO NOT INTEND TO PAY DIVIDENDS.
We have never declared or paid any cash dividends on our common stock. We
currently intend to retain any future earnings for funding growth and,
therefore, do not expect to pay any dividends in the foreseeable future. See
"Dividend Policy" for a history of our dividend payments.
17
<PAGE> 29
FORWARD-LOOKING STATEMENTS
We are of the opinion that some of the information contained in this prospectus
contains forward-looking statements that involve substantial risks and
uncertainties. These statements include, among others, the following:
- use of proceeds,
- our alternate fee structures,
- projected advertising revenues,
- projected increases in sales and marketing, research and development and
capital expenditures,
- liquidity,
- our expansion strategy into the home, corporate and international markets,
- our enhancements of the Searchopolis portal and
- our development of strategic relationships.
We have based these forward-looking statements on our current expectations and
projections about future events.
Forward-looking statements typically are identified by the use of such terms as
"may," "will," "expect," "believe," "anticipate," "estimate," "plan" and similar
words, although some forward-looking statements are expressed differently. You
should be aware that our actual growth and results could differ materially from
those contained in the forward-looking statements due to a number of factors,
including among others:
- our inability to attract sufficient customers in the home, corporate or
international markets, and
- lack of acceptance of our alternate fee structures by our customers.
You should also consider carefully the statements under "Risk Factors" and other
sections of this prospectus, which address additional factors that could cause
our actual results to differ from those found in the forward-looking statements.
In addition, this prospectus includes market data relating to us and the school,
home and corporate internet markets. Some of this data was obtained from
industry publications and reports, such as reports by International Data
Corporation, The Annenberg Public Policy Center and Quality Education Data.
These reports assume certain events, trends and activities will occur and they
project information on those assumptions. We have not independently verified
this data. Also, we have not sought the consent of all of these organizations to
refer to their reports in this prospectus.
18
<PAGE> 30
USE OF PROCEEDS
Our net proceeds from the sale of the 4,450,000 shares of common stock offered
by us are estimated to be approximately $44.9 million based on an assumed
initial public offering price of $11.00 per share and after deducting estimated
underwriting discounts and commissions and estimated offering expenses payable
by us. If the underwriters exercise the over-allotment option in full, our net
proceeds are estimated to be $51.8 million. See "Underwriting." We will not
receive any proceeds from the sale of common stock by the selling shareholders.
We plan to use the net proceeds of this offering for working capital and general
corporate purposes. We estimate that these will include, but may not be limited
to, the following:
- approximately $14 million for increased domestic and international sales and
marketing expenditures,
- approximately $6 million for increased research and development expenditures,
- approximately $5 million as general working capital and
- approximately $20 million for capital expenditures made in the ordinary
course of business, including approximately $8 million for filtering servers
and approximately $10 million for enhancement of Searchopolis.
We may also use a portion of the net proceeds for acquisitions of businesses,
products and technologies or the establishment of joint ventures that are
complementary to our current and future business. From time to time we evaluate
specific businesses, products or technologies that we may acquire, but there are
no current agreements or understandings with respect to any such transactions.
This represents our current intentions regarding use of the net proceeds from
this offering. Future events, as well as changes in economic, regulatory or
competitive conditions in our business may result in our making changes in the
use of these proceeds. Our management has broad discretion as to the allocation
of the net proceeds of this offering. See "Risk Factors -- Our Management Has
Broad Discretion Over the Use of Proceeds from this Offering" for a discussion
of risks associated with our use of the proceeds.
Until we use the net proceeds of the offering, we will invest the funds in
short-term, investment grade, interest bearing securities.
DIVIDEND POLICY
We have never declared or paid any cash dividends on our capital stock and do
not expect to do so in the foreseeable future. We anticipate that we will retain
any future earnings to develop and expand our business. Any future determination
with respect to the payment of dividends will be at the discretion of our board
of directors and will depend upon, among other things, our operating results,
financial condition and capital requirements, the terms of then-existing
indebtedness, general business conditions and other factors our board of
directors deems relevant. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Liquidity and Capital Resources" for a
discussion of our liquidity and anticipated future operating expenses.
19
<PAGE> 31
CAPITALIZATION
The following table shows, as of March 31, 1999:
- our actual capitalization,
- our pro forma capitalization after giving effect to the private sale of
additional common stock in May 1999, and the elimination of some of our
long-term debt that has been repaid from the proceeds of that sale and
- our pro forma capitalization as adjusted to reflect the sale of the 4,450,000
shares of common stock offered by us in this offering at an assumed initial
public offering price of $11.00 per share, after deducting estimated
underwriting discounts and commissions and estimated offering expenses.
The "actual" column in the table is based on shares outstanding as of March 31,
1999 and excludes:
- 1,840,830 shares subject to options outstanding, with an average exercise
price of $0.37 per share,
- 465,000 shares that could be issued upon exercise of warrants outstanding,
with an exercise price of $3.14 per share and
- 93,000 shares of common stock that could be issued upon exercise of warrants,
with an exercise price of $0.004 per share, which will be cancelled upon the
completion of this offering.
On June 11, 1999, our shareholders approved an increase in the authorized number
of shares to 50,000,000 shares of preferred stock and 250,000,000 shares of
common stock. The capitalization information found in the table is qualified by,
and should be read in conjunction with, our more detailed financial statements
and notes to those statements appearing elsewhere in this prospectus.
<TABLE>
<CAPTION>
MARCH 31, 1999
----------------------------------
PRO FORMA AS
ACTUAL PRO FORMA ADJUSTED
------- --------- ------------
(dollars in thousands, unaudited)
<S> <C> <C> <C>
Short-term debt, including current portion(1)............... $ 2,620 $ 674 $ 674
======= ======= =======
Long-term debt, less current portion(1)..................... 775 775 775
------- ------- -------
Shareholders' equity (deficit)
Preferred stock, no par value, 10,000,000 shares
authorized, none issued and outstanding actual; no
shares issued and outstanding pro forma and pro forma
as adjusted............................................ --
Common stock, no par value, 20,000,000 shares authorized;
12,656,933 shares issued and outstanding actual;
15,362,581 shares issued and outstanding pro forma;
19,812,581 shares issued and outstanding pro forma as
adjusted............................................... 5,181 14,981 59,875
Deferred stock option compensation expense................ (658) (658) (658)
Accumulated equity (deficit).............................. (6,359) (6,413) (6,413)
------- ------- -------
Total shareholders' (deficit) equity.............. (1,836) 7,910 52,804
======= ======= =======
Total capitalization............................ $(1,061) $ 8,685 $53,579
======= ======= =======
</TABLE>
- ---------------------------
(1) Includes capital lease obligations.
20
<PAGE> 32
DILUTION
N2H2's net tangible book value on March 31, 1999 was approximately $(1,836,000)
or $(0.15) per share. "Net tangible book value" is total assets minus the sum of
liabilities and intangible assets. "Net tangible book value per share" is net
tangible book value divided by the total number of shares outstanding before the
offering.
After giving effect to adjustments relating to the private sale on May 11, 1999
of 2,705,648 shares of additional common stock resulting in net proceeds to the
Company of $9.8 million, our pro forma net tangible book value was $7,910,000 or
$0.52 per share.
Our net tangible book value, on a proforma basis as further adjusted for the
sale of 4,450,000 shares of common stock offered by us in this offering after
deducting underwriting discounts, commissions, and other estimated offering
expenses would have been approximately $2.67 per share.
The following table illustrates the pro forma as adjusted increase in net
tangible book value of $2.15 per share and the dilution, which is the difference
between the offering price per share and net tangible book value per share, to
new investors:
<TABLE>
<S> <C> <C>
Initial public offering price per share..................... $11.00
Pro forma net tangible book value per share before the
offering.................................................. $0.52
Increase in net tangible book value per share attributable
to the offering........................................... 2.15
-----
Pro forma as adjusted net tangible book value per share
after giving effect to the offering....................... 2.67
------
Dilution per share to new investors in the offering......... $ 8.33
======
</TABLE>
The following table shows the difference between existing shareholders and new
investors with respect to the number of shares purchased from us, the total
consideration paid and the average price per share. The table assumes that the
initial public offering price will be $11.00 per share. Sales by the selling
shareholders in this offering will reduce the number of shares held by existing
shareholders to 15,312,581 or 77.3% of the total number of shares of common
stock outstanding after the offering. In addition, the sales by the selling
shareholders will increase the number of shares held by new investors to
4,500,000 or 22.7% of the total number of shares of common stock outstanding
after the offering. If the over-allotment option is exercised in full and sold
by the selling shareholders, sales by the selling shareholders in this offering
will increase the number of shares held by new investors to 5,175,000 or 26.1%
of the total number of shares of common stock outstanding after the offering.
<TABLE>
<CAPTION>
SHARES TOTAL
PURCHASED CONSIDERATION
-------------------- --------------------- AVERAGE PRICE
NUMBER PERCENT AMOUNT PERCENT PER SHARE
---------- ------- ----------- ------- -------------
<S> <C> <C> <C> <C> <C>
Existing shareholders.................. 15,362,581 77.5% $12,784,434 20.7% $ 0.83
New investors.......................... 4,450,000 22.5 48,950,000 79.3 11.00
---------- ----- ----------- ------
Total........................ 19,812,581 100.0% $61,734,434 100.0%
========== ===== =========== ======
</TABLE>
- -------------------------
The foregoing discussion and tables assume no exercise of the underwriters'
over-allotment option or of any outstanding stock options or warrants after
March 31, 1999. As of March 31, 1999, there were outstanding options to purchase
1,840,830 shares of common stock at an average exercise price per share of $0.37
and warrants to purchase an aggregate of 558,000 shares at an average exercise
price per share of $2.62. You will suffer further dilution to the extent any of
these options or these warrants are exercised.
21
<PAGE> 33
SELECTED FINANCIAL DATA
This section presents selected historical financial data of N2H2. You should
read carefully the financial statements included in this prospectus, including
the notes to the financial statements. The selected data in this section is not
intended to replace the financial statements.
We derived the statement of operations data for the fiscal years ended September
30, 1996, 1997 and 1998 and balance sheet data as of September 30, 1997 and
1998, from the audited financial statements in this prospectus. The selected
balance sheet data found below for us as of September 30, 1996 is derived from
our audited financial statements not included in this prospectus. Those
financial statements were audited by PricewaterhouseCoopers LLP, independent
accountants. We derived the statements of operations data for the six months
ended March 31, 1998 and 1999 and balance sheet data as of March 31, 1998 and
1999 from the unaudited financial statements included in this prospectus. We
believe that the unaudited historical statements contain all adjustments needed
to present the information included in those statements and that the adjustments
made consist only of normal recurring adjustments. The historical results are
not necessarily indicative of results to be expected for any future period. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" for a more complete discussion and analysis of the selected
financial data presented below.
<TABLE>
<CAPTION>
SIX MONTHS ENDED
FISCAL YEAR ENDED SEPTEMBER 30, MARCH 31,
------------------------------------ ------------------------
1996 1997 1998 1998 1999
---------- ---------- ---------- ---------- -----------
(dollars in thousands, except per share dat(unaudited)
<S> <C> <C> <C> <C> <C>
STATEMENT OF OPERATIONS DATA:
Revenues............................ $ 108 $ 1,118 $ 3,078 $ 1,298 $ 2,605
Cost of revenues.................... 78 302 1,153 453 1,254
---------- ---------- ---------- ---------- -----------
Gross profit........................ 30 816 1,925 845 1,351
Operating expenses:
Sales and marketing............... 263 605 1,752 679 1,535
Research and development.......... 91 371 614 252 394
General and administrative........ 493 602 1,869 483 1,190
---------- ---------- ---------- ---------- -----------
Total operating
expenses................ 847 1,578 4,235 1,414 3,119
---------- ---------- ---------- ---------- -----------
Operating loss...................... (817) (762) (2,310) (569) (1,768)
Interest expense, net............... (10) (119) (287) (110) (247)
---------- ---------- ---------- ---------- -----------
Net loss............................ $ (827) $ (881) $ (2,597) $ (679) $ (2,015)
========== ========== ========== ========== ===========
Basic and diluted net loss per
share(1).......................... $ (0.11) $ (0.10) $ (0.30) $ (0.08) $ (0.19)
========== ========== ========== ========== ===========
Basic and diluted weighted average
shares outstanding(1)............. 7,316,858 8,389,878 8,687,435 8,686,411 10,758,005
</TABLE>
22
<PAGE> 34
<TABLE>
<CAPTION>
SEPTEMBER 30, MARCH 31,
------------------------------------ ------------------------
1996 1997 1998 1998 1999
---------- ---------- ---------- ---------- -----------
(DOLLARS IN THOUSANDS) (UNAUDITED)
<S> <C> <C> <C> <C> <C>
BALANCE SHEET DATA:
Cash................................ $ 128 $ 71 $ 121 $ 88 $ 1,384
Working capital (deficit)........... 27 (829) (2,234) (910) (3,051)
Property and equipment, net......... 163 453 1,271 772 2,045
Total assets........................ 400 784 1,848 1,034 4,285
Long-term obligations, excluding
current portion(2)................ 544 826 1,942 1,781 775
Total shareholders' deficit......... (352) (1,201) (2,904) (1,880) (1,836)
</TABLE>
- ---------------------------
(1) See Note 10 of the Notes to Financial Statements for an explanation of the
determination of the number of shares used in computing the share data.
(2) Includes capital lease obligations.
23
<PAGE> 35
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
You should read this section together with the financial statements and other
financial information included in this prospectus. This discussion contains
forward-looking statements that involve risks and uncertainties. Our actual
results may differ materially from those indicated in these forward-looking
statements.
OVERVIEW
N2H2 develops and provides internet filtering solutions to schools, homes,
internet service providers, corporations and other organizations. Our services
enable our customers to limit access to the internet by allowing them to select
their own filter criteria from our 32 areas of categorized internet content. Our
categories range from pornography, hate and bomb construction to gambling and
games. Our filtering solutions require minimal customer effort for installation
and maintenance. In addition, our proxy-server based system updates our clients'
filtering criteria on a daily basis to reflect the continual addition or
modification of new or existing Websites on the internet.
We recently introduced Searchopolis, our education oriented internet portal. We
created Searchopolis to maximize the educational capabilities of the internet
for students, teachers, parents and administrators by aggregating internet based
educational content in one place. Searchopolis was designed to work in
conjunction with our award winning filtering search technology and is available
at www.searchopolis.com to any internet user who wants access to a safe,
educationally oriented internet portal.
We were incorporated in June 1995 and introduced the industry's first proxy
server based internet filter in September 1995. As of May 31, 1999, we had
accomplished the following:
- provide filtering service to approximately 7.3 million students in
approximately 8,000 schools in the United States and Canada.
- individually reviewed and categorized over 2.2 million Websites and partial
Websites,
- created a database of 32 categories of internet content that can be selected
for filtering by our customers,
- had users access approximately 349 million Web pages through our services in
the month of May 1999,
- installed and shipped approximately 725 internet filtering proxy servers in
the United States, Canada, Australia, United Kingdom, Germany, Chile, Mexico,
India and Bermuda,
- introduced our education portal, Searchopolis.com, in October 1998,
- provided our services to approximately 150,000 homes through approximately
190 internet service providers,
- entered into strategic corporate relationships with Inktomi, Looksmart and
others and
- grown to 154 employees, including 92 full time and 62 part time employees.
Since inception, we have derived substantially all of our revenues through a
combination of subscription and installation fees from our internet filtering
services. Customers pay a one-time installation fee and enter into a
subscription contract, which is typically 12 months in duration. We recognize
installation revenues upon shipment of our servers and subscription revenues on
a straight line basis over the life of the subscription contract term.
We plan to offer alternate fee structures to our school customers that will give
them the choice of paying our recurring subscription fees or receiving our
filtering services at reduced rates or without charge in exchange for allowing
us to sell sponsorship rights to advertisers and to make Searchopolis the
default search engine on their networks. To the extent our customers do choose
to accept advertising from our
24
<PAGE> 36
sponsors, we will lose some or all of our subscription revenues from those
customers. Our customers may not accept our alternate fee structures, and the
impact on our revenues is unpredictable.
We are expanding our services to the education and other markets with
Searchopolis. We expect Searchopolis to generate additional advertising revenues
as well as revenues from offering specialized communication features including
access-controlled, filtered e-mail, an easy-to-use calendar, Virtual Locker,
access to monitored chat rooms and various teacher tools including GradeChecker.
To date, we have derived only limited internet advertising revenues from
indirect sales of advertisements on Searchopolis by our advertising partner,
24/7 Media, Inc. In the future, we expect to obtain a greater proportion of our
revenues from the direct and indirect sale of internet advertising. We expect
that these sales will be made to companies that advertise their products and
services over the internet to our target market of K-12 students. We currently
offer advertisers various sizes and types of advertising on Searchopolis through
24/7 Media. In the future, we expect to offer additional advertising as part of
our marketing of our internet filtering services and advanced communication
tools. We recognize advertising revenues, net of any commissions paid to an
advertising agency, in the period that the advertisement is displayed. We intend
to continue to increase the number and scope of our relationships with
advertising partners, such as 24/7 Media, as well as to significantly increase
the size of our internal advertising sales organization.
We have a limited operating history and our prospects are subject to the risks,
expenses and difficulties encountered by companies in the new and rapidly
evolving internet market. We have incurred significant net losses and negative
cash flows from operations since inception and, as of March 31, 1999, had
incurred operating losses of approximately $6.4 million. These losses have been
funded primarily through the issuance of common stock and debt. We intend to
continue to invest heavily in sales and marketing, technology and our operating
infrastructure. As a result, we expect to incur substantial net losses for the
foreseeable future. Historically low inflation rates over the past three years
have had an immaterial impact on our revenues and costs. In addition, neither
our prices nor those of our principal suppliers have changed significantly over
the past three years.
In view of the rapidly changing nature of our business and our limited operating
history, we believe that period-to-period comparisons of revenues and operating
results are not necessarily meaningful. You should not rely upon this
information as an indication of future performance.
Revenues. We generate our revenues from installation, subscription and
advertising fees. Our increasing revenues over the period to period comparisons
which follow have been due primarily to increased sales volume. While
installation revenues are typically higher in the summer months, we expect
advertising revenues to be significantly affected by the reduction of internet
use by schools and K-12 students during the summer months. User traffic on our
school customer systems has historically been lower during the summer and during
year-end vacation and holiday periods, and advertising revenues will likely be
less during these periods.
Cost of revenues. Cost of revenues consists of the costs of Website review,
depreciation of servers which we own and are installed at customer locations,
technical installation and support and telecommunications costs. Since April
1999, we have included search processing and hosting fees as cost of revenues in
recognition of advertising revenues received. These costs consist of expenses
incurred with outside providers of search engine and Web hosting services,
including Inktomi and Exodus. We expect that our costs of revenues will vary
from period to period and may increase as a percentage of revenues in future
quarters as we expand our operations and offer alternate fee structures to our
school customers. Expanding our operations will also entail additional customer
support personnel and Web site review costs. We anticipate that our alternate
fee structures will increase Searchopolis traffic and require us to incur
additional search processing and hosting costs.
Sales and marketing. Sales expenses consist primarily of salaries, commissions
and bonuses. Marketing expenses consist primarily of salaries, marketing
brochures, trade shows, direct mailing programs, advertising, public relations
and travel. We believe that a significant increase in sales and marketing
efforts
25
<PAGE> 37
is essential for us to continue to improve our market position. We anticipate
using approximately $14 million of the net proceeds from this offering for
increased domestic and international sales and marketing expenditures. Of that,
approximately $11.5 million may be directed domestically towards hiring
additional direct customer sales staff, advertising staff and expanding
marketing programs. The remaining $2.5 million may be targeted toward increased
international sales and marketing expenditures including hiring European
representatives. We anticipate that these increased sales and marketing efforts
would be carried out over the next two to three years.
Research and development. Research and development expenses consist primarily of
salaries and benefits for software developers, consulting fees, facilities costs
and equipment depreciation. In the development of new products and enhancement
of existing products, the technological feasibility of the service is not
established until substantially all product development is complete.
Accordingly, development costs and all costs related to internal research and
development have been expensed as incurred. We anticipate using approximately $6
million of the net proceeds from this offering for increased research and
development expenditures, primarily through the hiring of additional engineers
and other technical staff. Increased research and development expenditures may
be directed towards development of enhancements of our filtering technologies,
communications tools for Searchopolis and other future service enhancements not
presently defined.
General and administrative. General and administrative expenses consist
primarily of salaries, benefits and related costs for our executive, finance,
human resources and administrative personnel, third party professional service
fees and allocation of our facilities and depreciation expenses. We expect to
incur additional costs related to managing the financial, legal and
administrative aspects of our business. We also expect general and
administrative expenses to increase in the future, reflecting growth in our
operations and the costs associated with being a public company.
Income Taxes. Prior to May 1999 we were an S corporation for federal income tax
purposes, and effective May 11, 1999, became a C corporation. As a C
corporation, we are subject to income tax at the corporate level to the extent
we have generated net income. Any operating losses we incur will result in net
operating loss carryforwards available to offset future taxable income. A full
valuation allowance will be recorded against any deferred tax assets available
to us for use in future periods because realization of these assets is primarily
dependent on generating taxable net income in the future. We do not believe that
the change to C corporation status will have a material impact on our financial
position, results of operations or liquidity in future periods.
26
<PAGE> 38
RESULTS OF OPERATIONS
The following table sets forth selected statement of operations data as a
percentage of total revenues for the periods indicated:
<TABLE>
<CAPTION>
SIX MONTHS
FISCAL YEAR ENDED ENDED
SEPTEMBER 30, MARCH 31,
------------------------ --------------
1996 1997 1998 1998 1999
---- ---- ---- ---- ----
(Unaudited)
<S> <C> <C> <C> <C> <C>
Revenues......................................... 100% 100% 100% 100% 100%
Cost of revenues................................. 72 27 37 35 48
---- --- --- --- ---
Gross profit..................................... 28 73 63 65 52
---- --- --- --- ---
Operating expenses:
Sales and marketing............................ 244 54 57 52 59
Research and development....................... 84 33 20 20 15
General and administrative..................... 457 54 61 37 46
---- --- --- --- ---
Total operating expenses......................... 785 141 138 109 120
---- --- --- --- ---
Operating loss................................... (757) (68) (75) (44) (68)
Interest expense, net............................ (9) (11) (9) (8) (9)
---- --- --- --- ---
Net loss......................................... (766)% (79)% (84)% (52)% (77)%
==== === === === ===
</TABLE>
SIX MONTHS ENDED MARCH 31, 1999 COMPARED TO SIX MONTHS ENDED MARCH 31, 1998
(UNAUDITED)
Revenues. Our revenues increased by $1.3 million, or 101%, to $2.6 million for
the six months ended March 31, 1999, from $1.3 million for the six months ended
March 31, 1998. This increase was due primarily to increased sales of filtering
services. Revenues from installations increased by $410,000, or 75%, to $960,000
for the six months ended March 31, 1999, from $550,000 for the six months ended
March 31, 1998. Subscription revenues increased by $877,000, or 117%, to $1.6
million for the six months ended March 31, 1999, from $748,000 for the six
months ended March 31, 1998. We began recognizing advertising revenues of
approximately $21,000 in the six months ended March 31, 1999. As our revenue
base increases, we do not believe we can sustain our historical percentage
growth rates of revenue.
Cost of revenues. Our cost of revenues increased by $801,000, or 177%, to $1.3
million for the six months ended March 31, 1999, from $453,000 for the six
months ended March 31, 1998. Cost of revenues as a percentage of total revenues
increased to 48% for the six months ended March 31, 1999, from 35% for the six
months ended March 31, 1998. These increases were due primarily to increases in
customer support personnel costs.
Sales and marketing. Sales and marketing expenses increased by $856,000, or
126%, to $1.5 million for the six months ended March 31, 1999, from $679,000 for
the six months ended March 31, 1998. This increase was primarily due to the
hiring of additional sales and marketing personnel. Sales and marketing expenses
as a percentage of revenues increased to 59% for the six months ended March 31,
1999, from 52% for the six months ended March 31, 1998.
Research and development. Research and development expenses increased by
$142,000, or 56%, to $394,000 for the six months ended March 31, 1999, from
$252,000 for the six months ended March 31, 1998. Research and development
expenses for the six months ended March 31, 1999, were related primarily to the
continued development of our filtering and Searchopolis services. In future
quarters, we expect research and development expenses to increase in amount and
to vary as a percentage of revenues. Research and development expenses as a
percentage of revenues decreased to 15% for the six months ended March 31, 1999,
from 20% for the six months ended March 31, 1998.
27
<PAGE> 39
General and administrative. General and administrative expenses increased by
$707,000, or 146%, to $1,190,000 for the six months ended March 31, 1999, from
$483,000 for the six months ended March 31, 1998. This increase was primarily
due to increased personnel costs to support the continued growth of our business
and non-cash stock compensation costs in the amount of $306,000 associated with
common stock and options issued during the period. General and administrative
expenses as a percentage of revenues was 46% for the six months ended March 31,
1999 and 1998.
FISCAL YEAR ENDED SEPTEMBER 30, 1998 COMPARED TO FISCAL YEAR ENDED SEPTEMBER 30,
1997
Revenues. Our revenues increased by $2.0 million, or 175%, to $3.1 million for
the fiscal year ended September 30, 1998, from $1.1 million for the fiscal year
ended September 30, 1997. Installation and subscription revenues accounted for
substantially all the revenues for the fiscal year ended September 30, 1998.
Installation revenues increased $784,000, or 138%, to $1.4 million for the
fiscal year ended September 30, 1998, from $570,000 for the fiscal year ended
September 30, 1997. Installation revenues accounted for 44% of total revenues
for the fiscal year ended September 30, 1998, compared to 51% for the fiscal
year ended September 30, 1997. The increase in installation revenues was due
primarily to sales to new customers. Subscription revenues increased by $1.2
million, or 215%, to $1.7 million for the fiscal year ended September 30, 1998,
from $548,000 for the fiscal year ended September 30, 1997. Subscription
revenues as a percentage of total revenues increased to 56% for the fiscal year
ended September 30, 1998, compared to 49% for the fiscal year ended September
30, 1997. Subscription revenues increased at a higher rate than installation
revenues primarily due to renewals of subscription contracts by existing
customers.
Cost of revenues. Cost of revenues increased by $851,000, or 282%, to $1.2
million for the fiscal year ended September 30, 1998, from $302,000 for the
fiscal year ended September 30, 1997. Cost of revenues as a percentage of total
revenues increased to 37% for the fiscal year ended September 30, 1998, compared
to 27% for the fiscal year ended September 30, 1997. The increase was due
primarily to increases in customer support personnel costs.
Sales and marketing. Sales and marketing expenses increased by $1.2 million, or
190%, to $1.8 million for the fiscal year ended September 30, 1998, from
$605,000 for the fiscal year ended September 30, 1997. This increase was
primarily due to the hiring of additional sales and marketing personnel. Sales
and marketing expenses represented 57% of our total revenues for the fiscal year
ended September 30, 1998 and 54% of our total revenues for the fiscal year ended
September 30, 1997.
Research and development. Research and development expenses increased by
$243,000, or 66%, to $614,000 for the fiscal year ended September 30, 1998, from
$371,000 for the fiscal year ended September 30, 1997. This increase was
primarily due to an increase in the number of software developers and technical
personnel supporting development of our filtering and Searchopolis services. Our
research and development expenses as a percentage of revenues decreased to 20%
for the fiscal year ended September 30, 1998, from 33% for the fiscal year ended
September 30, 1997. This decrease was due primarily to increased revenues.
General and administrative. General and administrative expenses increased by
$1,267,000, or 210%, to $1.8 million for the fiscal year ended September 30,
1998, from $602,000 for the fiscal year ended September 30, 1997. This increase
was primarily due to the addition of personnel to support the growth of our
business and non-cash deferred stock compensation costs in the amount of
$819,000 associated with warrants and options granted during the period. General
and administrative expenses as a percentage of revenues increased to 61% in the
fiscal year ended September 30, 1998, from 54% in the fiscal year ended
September 30, 1997. We expect that our general and administrative expenses will
continue to increase in amount in the future as we continue to build our
administrative staff and operating infrastructure.
FISCAL YEAR ENDED SEPTEMBER 30, 1997 COMPARED TO FISCAL YEAR ENDED SEPTEMBER 30,
1996
Revenues. Our revenues increased by $1.0 million, or 936%, to $1.1 million for
the fiscal year ended September 30, 1997, from $108,000 for the fiscal year
ended September 30, 1996. This increase reflects
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<PAGE> 40
both the effects of the increasing number of servers installed and subscription
renewals. Installation and subscription revenues accounted for substantially all
the revenues for the fiscal year ended September 30, 1997. Installation revenues
increased by $488,000, or 595%, to $570,000 for the fiscal year ended September
30, 1997, from $82,000 for the fiscal year ended September 30, 1996.
Installation revenues accounted for 51% of total revenues for the fiscal year
ended September 30, 1997, compared to 76% for the fiscal year ended September
30, 1996. Subscription services revenues increased by $522,000, or 2,008%, to
$548,000 for the fiscal year ended September 30, 1997, from $26,000 for the
fiscal year ended September 30, 1996. Subscription revenues as a percentage of
total revenues increased to 49% for the fiscal year ended September 30, 1997,
compared to 24% for the fiscal year ended September 30, 1996.
Cost of revenues. Cost of revenues increased by $224,000, or 289%, to $302,000
for the fiscal year ended September 30, 1997, from $78,000 for the fiscal year
ended September 30, 1996. This increase was primarily due to an increase in the
number of Website reviewers. Cost of revenues as a percentage of total revenues
decreased to 27% for the fiscal year ended September 30, 1997, compared to 72%
for the fiscal year ended September 30, 1996. This decrease was primarily due to
increased revenues.
Sales and marketing. Sales and marketing expenses increased by $342,000, or
130%, to $605,000, for the fiscal year ended September 30, 1997, from $263,000
for the fiscal year ended September 30, 1996. This increase was primarily due to
the hiring of additional sales and marketing personnel. Sales and marketing
expenses as a percentage of total revenues decreased to 54% for the fiscal year
ended September 30, 1997, compared to 244% for the fiscal year ended September
30, 1996, primarily due to increased revenues.
Research and development. Research and development expenses increased by
$280,000, or 307%, to $371,000 for the fiscal year ended September 30, 1997,
from $91,000 for the fiscal year ended September 30, 1996. This increase was
primarily due to an increase in the number of software developers and technical
personnel supporting development of our filtering services. Our research and
development expenses as a percentage of total revenues decreased to 33% for the
fiscal year ended September 30, 1997, compared to 84% for the fiscal year ended
September 30, 1996.
General and administrative. General and administrative expenses increased by
$109,000, or 22%, to $602,000 for the fiscal year ended September 30, 1997, from
$493,000 for the fiscal year ended September 30, 1996. This increase was
primarily due to increases in consulting fees paid. General and administrative
expenses as a percentage of total revenues decreased to 54% for the fiscal year
ended September 30, 1997, compared to 457% for the fiscal year ended September
30, 1996, primarily because of the growth in revenues.
SELECTED QUARTERLY OPERATING RESULTS
The following table sets forth unaudited quarterly statement of operations data
for the six quarters ended March 31, 1999, as well as the percentage of our
revenues represented by each item. This data has been derived from unaudited
financial statements that have been prepared on the same basis as our audited
financial statements and, in our opinion, includes all adjustments, consisting
of normal recurring adjustments, that we consider necessary for a fair
presentation of such information when read in conjunction with our audited
financial statements and the notes to those statements included elsewhere in
this prospectus.
We have incurred operating losses since inception and we cannot be certain that
we will achieve profitability on a quarterly or annual basis in the future. We
believe that future operating results will be subject to quarterly fluctuations,
and, as a result, we believe that results of operations for interim periods
should not be relied upon as any indication of the results to be expected in any
future period. See "Risk
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<PAGE> 41
Factors -- Our Quarterly Financial Results Fluctuate and May Be Affected by
Seasonal Variations" for a description of the risks associated with quarterly
fluctuations.
<TABLE>
<CAPTION>
THREE MONTHS ENDED
------------------------------------------------------------------------------
DECEMBER 31, MARCH 31, JUNE 30, SEPTEMBER 30, DECEMBER 31, MARCH 31,
1997 1998 1998 1998 1998 1999
------------ --------- -------- ------------- ------------ ---------
(DOLLARS IN THOUSANDS, UNAUDITED)
<S> <C> <C> <C> <C> <C> <C>
Revenues....................... $ 604 $ 694 $ 675 $1,105 $1,189 $ 1,416
Cost of revenues............... 201 252 317 383 532 722
----- ----- ----- ------ ------ -------
Gross profit................... 403 442 358 722 657 694
Operating expenses:
Sales and marketing.......... 286 393 481 592 638 897
Research and development..... 116 136 175 187 186 208
General and administrative... 244 239 316 1,070 328 862
----- ----- ----- ------ ------ -------
Total operating expense... 646 768 972 1,849 1,152 1,967
Operating loss................. (243) (326) (614) (1,127) (495) (1,273)
Interest expense, net.......... (50) (61) (54) (122) (155) (92)
----- ----- ----- ------ ------ -------
Net loss....................... $(293) $(387) $(668) $(1,249) $ (650) $(1,365)
===== ===== ===== ====== ====== =======
PERCENTAGE OF REVENUES
Revenues....................... 100% 100% 100% 100% 100% 100%
Cost of revenues............... 33 36 47 35 45 51
----- ----- ----- ------ ------ -------
Gross profit................... 67 64 53 65 55 49
Operating expenses:
Sales and marketing.......... 47 57 71 54 54 63
Research and development..... 19 20 26 17 16 15
General and administrative... 41 34 47 97 27 61
----- ----- ----- ------ ------ -------
Total operating expense... 107 111 144 168 97 139
Operating loss................. (40) (47) (91) (103) (42) (90)
Interest expense, net.......... (8) (9) (8) (11) (13) (7)
----- ----- ----- ------ ------ -------
Net loss....................... (48)% (56)% (99)% (114)% (55)% (97)%
===== ===== ===== ====== ====== =======
</TABLE>
LIQUIDITY AND CAPITAL RESOURCES
Since inception, we have funded our operations primarily through private sales
of equity securities, the use of short-term and long-term debt and capital
leases. As of March 31, 1999, we had cash and cash equivalents of $1.4 million.
Our operating activities resulted in net cash outflows of $304,000 in 1996 and
$427,000 in 1997 and a net cash inflow of $286,000 in 1998. For the six months
ended March 31, 1999, our operating activities resulted in a net cash outflow of
$1.4 million. The operating cash outflows in 1996, 1997 and the six months ended
March 31, 1999 resulted from net operating losses and increases in accounts
receivable due to increased sales. The operating cash inflow in 1998 resulted
primarily from increases in prepayment of subscription fees, accounts payable
and accrued liabilities.
Capital expenditures, excluding those under capital leases, totaled $121,000,
$230,000 and $383,000 in 1996, 1997 and 1998 and $416,000 in the six months
ended March 31, 1999. We anticipate that we will continue to experience an
increase in capital expenditures consistent with our anticipated growth in
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installations of new proxy servers and purchases of equipment in support of our
increasing operations, administrative infrastructure and personnel.
Our financing activities provided $545,000 in 1996, $600,000 in 1997 and
$147,000 in 1998 and $3.1 million in the six months ended March 31, 1999. For
1996, cash provided by financing activities consisted primarily of $275,000
received in connection with the sale of common stock and $285,000 in proceeds
from long-term borrowings, reduced by $15,000 in payments on capital lease
obligations. For 1997, cash provided by financing activities consisted primarily
of $631,000 in proceeds from long-term borrowings, reduced by $31,000 in
payments on capital lease obligations. For 1998, cash provided by financing
activities consisted primarily of $210,000 in proceeds from long-term
borrowings, reduced by $51,000 in payments on capital lease obligations and
repayments of notes payable. For the six months ended March 31, 1999, cash
provided by financing activities consisted primarily of $2.0 million received in
connection with the sale of common stock and warrants and $2.0 million in
proceeds from long-term debt borrowings, less $201,000 of payments under capital
lease obligations and $669,000 of repayments on notes payable.
On April 30, 1999, we entered into a term loan and revolving line of credit
agreement with Imperial Bank. The term loan is secured by a first priority claim
against all of our unpledged assets. The term loan provides for maximum
borrowings of $2.0 million if specified conditions are met. The revolving line
of credit provides for draws of 80% of accounts receivable assigned as security
up to a maximum short-term borrowing of $2.0 million if specified conditions are
met. As of July 7, 1999, the amount available for borrowing under the term loan
and revolving line of credit totaled $1.8 million. Advances on the term loan
bear interest on the outstanding daily balance at N2H2's election at the rate of
either (a) 1.0% above the prime rate as announced by Imperial Bank or (b) at a
rate equal to the LIBOR plus 400 basis points. Advances on the revolving line of
credit bear interest on the outstanding daily balance at a rate of 0.5% above
the prime rate as announced by Imperial Bank.
On May 11, 1999, we completed a private equity financing in which we raised
$10.0 million through the sale of 2,705,648 shares of common stock at a price
per share of $3.70. This private financing was conducted to retire $2.0 million
in outstanding long-term debt and to ensure our ability to fund increased
marketing and installation activities at the beginning of the 1999 academic
summer recess, a crucial marketing period for us.
We intend to substantially increase our operating expenses in 1999 and beyond as
we:
- enter new markets with our services and further develop our sales channels
and international sales presence,
- introduce an enhanced version of Searchopolis with new communication tools
and incur increased depreciation costs for equipment supporting Searchopolis,
- incur increased depreciation expenses related to installing additional
servers in customer networks,
- hire additional software development, sales and marketing, and general and
administrative personnel,
- implement new and upgraded operational and financial systems, procedures and
controls,
- assume the responsibilities of being a public company and
- expand our customer support and service operations.
These increased operating expenses, together with capital expenditures related
to filtering servers and enhancement of Searchopolis, will consume a significant
amount of our cash resources, including a portion of the net proceeds of this
offering. We believe that the net proceeds of this offering, together with cash
from operations, will be sufficient to meet our anticipated cash needs for at
least the next 12 months. If cash generated from operations is insufficient to
satisfy our liquidity requirements, we may seek to sell additional equity or
debt securities or to obtain a larger credit facility. The sale of additional
equity or convertible debt securities would result in additional dilution to our
shareholders. The incurring of indebtedness would result in increased fixed
obligations and could result in covenants that would restrict
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our operations. We have not made arrangements to obtain additional financing and
we cannot assure you that financing will be available in amounts or on terms
acceptable to us, if at all. See "Risk Factors -- Our Future Capital Needs Are
Uncertain" for a description of risks associated with a decrease in liquidity.
RECENT ACCOUNTING PRONOUNCEMENTS
Statement of Financial Accounting Standards No. 128, "Earnings Per Share" issued
February 1997, requires presentation of earnings per share on a basic and
diluted earnings per share basis. Our earnings per share for all periods
presented have been stated to reflect the adoption of SFAS No. 128. Under the
provisions of SFAS No. 128, basic earnings per share is calculated as income
available to common shareholders divided by the weighted average number of
shares of common stock and common stock equivalents outstanding during the
period, including options and warrants computed using the treasury stock method.
In March 1998, the Accounting Standards Executive Committee of the American
Institute of Certified Public Accountants issued SOP 98-1, Accounting for the
Costs of Computer Software Developed or Obtained for Internal Use. SOP 98-1
provides guidance for an enterprise on accounting for the costs of computer
software developed or obtained for internal use. SOP 98-1 is effective for our
fiscal year 1999. We anticipate that accounting for transactions under SOP 98-1
will not have a material impact on our financial condition or results of
operations.
THE YEAR 2000
Background of year 2000 issues. Many currently installed computer systems and
software products are unable to distinguish between 20th century dates and 21st
century dates because such systems were developed using two digits rather than
four to determine the applicable year. For example, computer programs that have
date-sensitive software may recognize a date using "00" as the year 1900 rather
than the year 2000. This error could result in system failures or
miscalculations causing disruptions of operations, including, among other
things, a temporary inability to process transactions, send invoices or engage
in similar normal business activities. As a result, many companies' software and
computer systems may need to be upgraded or replaced to comply with "year 2000"
requirements.
Our internal systems. Our business is dependent on the operation of numerous
systems that could potentially be affected by year 2000 related problems. Those
systems include, among others, hardware and software systems used by us to
deliver products and services to our customers, communications networks such as
the internet and private intranets, the internal systems of our customers and
suppliers, software portions of products licensed to customers, the hardware and
software systems used internally by us in the management of our business and
non-information technology systems and services used by us in the management of
our business, such as power, telephone systems and building systems.
Our network is critical to providing top quality, reliable service to our
customers. Our goal is to maintain this quality and provide uninterrupted
service through the turn of the century. Our year 2000 program is
enterprise-wide and is focused on the following interrelated categories, which
include both software and hardware critical to maintaining uninterrupted service
to our customers:
- our own computer networks and proxy server equipment,
- applications, products and services we have developed,
- external interfaces of our networks and applications,
- our customers' information technology platforms that support our
applications,
- other information and computer systems which are essential to conduct
business but that do not affect our ability to provide services and products
to customers and
- our non-information technology infrastructure.
Our readiness. The key milestones to our year 2000 program have been internal
and external assessment, testing and repair. We have completed both our internal
and external year 2000 compliance assessment.
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We believe that we have identified and reviewed the internally and externally
developed software that supports the development and delivery of our services
and products or is necessary to maintain our administration, sales and
accounting functions. We have completed our assessment of this software and have
made the changes we consider necessary.
Costs of addressing year 2000 compliance. To date, we have spent an immaterial
amount on year 2000 compliance. We do not believe the cost of preparing for year
2000 compliance will exceed $50,000, exclusive of labor costs not specifically
allocated to year 2000 compliance matters. If we are wrong, we could face
additional unexpected expenses to fix any year 2000 problems.
Our external products vendors and systems. We use third party equipment and
software that may not be year 2000 compliant. We have reviewed our externally
purchased network elements, including switches, routers, proxy servers and
network control points and do not believe they will be affected by year 2000
concerns. We identified our fax server software as noncompliant and have
replaced it with a compliant version. We have also reviewed other systems that
are important to our business such as telecommunications, energy and
environmental management. We identified no significant problems associated with
year 2000 issues in these systems. While not all our vendors have delivered
assurances that they will be year 2000 compliant, we have not encountered any
material year 2000 problems with servers, software or information systems
provided to us by third parties.
Contingency planning. We have not developed a formal year 2000 contingency plan.
Based on our assessment to date and our readiness activities, we do not
anticipate needing to develop such a plan. As part of the overall growth of our
network services, we are increasing our telecommunication bandwidth capabilities
and purchasing and distributing servers to multiple locations. These plans,
while not specific to the year 2000 issue, could mitigate unforeseen year 2000
problems by establishing redundancy in our system.
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BUSINESS
INTRODUCTION
N2H2 is a leading provider of internet content filtering services to schools. We
are now extending the availability of our filtering services into increasing
numbers of homes, through approximately 190 internet service providers, and to
corporations and other organizations. We were the first company to offer a
server-based internet filtering solution for a customer's computer network. With
Bess, our flagship product, we currently provide filtering services to
approximately 7.3 million students in approximately 8,000 schools in the United
States and Canada. To capitalize on our existing base of school customers, we
introduced our education oriented internet portal called Searchopolis, which is
designed to appeal to K-12 students. Searchopolis incorporates our award winning
filtering search technology and is available at www.searchopolis.com to any
internet user who wants access to a safe, educationally enriched internet
portal. We began our operations in 1995 and are incorporated in Washington
state.
Our filtering services enable our school and other customers to limit access to
the internet by allowing them to select from among 32 content categories,
including pornography, profanity, hate crime advocacy, drugs, violence, weapons
instruction and other potentially unsuitable material. Customer control over the
selection of filtering criteria for internet content is one of the key features
of our filtering solutions. Our customers include:
- the statewide networks serving most of the public schools in
- Ohio,
- Tennessee,
- Maine,
- Oklahoma and
- Wisconsin, and
- school systems in areas such as
- Los Angeles County,
- Baltimore,
- Boston,
- Calgary,
- Seattle,
- Stockton and
- Tampa.
During May 1999, students and teachers accessed approximately 349 million Web
pages through Bess. We believe the number of users accessing the internet
through our filtering services presents a significant opportunity for us to sell
advertising to sponsors who wish to reach K-12 students.
We intend to promote Searchopolis as the premier education oriented portal,
capitalizing on our existing base of school customers using Bess to filter
internet content. Searchopolis improves the educational potential of the
internet by assembling educational content in one place and providing safe
access to the Web through our filtering search technology. We are developing and
plan to integrate additional specialized communication services into
Searchopolis to enhance its capability to serve as the portal of choice for the
community of students, teachers, parents and administrators. These features will
include: access-controlled, filtered e-mail, an easy-to-use calendar linking
schools, students and teachers, a "Virtual Locker" to store students' favorite
internet sites, classroom material and homework for access from the home,
library or other locations outside the classroom, and GradeChecker, which will
provide students, teachers and parents with internet access to grades and other
classroom information.
We believe that Bess's strong reputation among teachers and parents, combined
with the growing use of the internet at home by students, will increase the
demand for our filtering services in the residential market. We also develop,
market and support internet filtering solutions that enable businesses to
increase
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productivity by limiting the content that employees can access on the internet
without blocking material that is appropriate and useful for their jobs. In
addition to filtering pornography and other potentially unsuitable materials,
our services enable customers to limit access to chat, sports, gambling, free
e-mail and other selected categories of sites. We are pursuing marketing
alliances with companies in the United States and overseas to increase our
penetration of the corporate market. We recently entered into an agreement with
Computer Sciences Corporation to provide company wide filtering of employee
internet use. We also have a marketing alliance with GTE Interactive to provide
internet filtering for hotel guest rooms.
Our complete filtering solutions offer the following key benefits:
- automated identification of Websites backed by human review to accurately
place internet content into a database of 32 categories,
- customer choice of filtering categories with password-based override for
authorized users,
- ability to restrict access to Websites soliciting personal information from
users,
- minimal customer effort required for installation and maintenance,
- server-based filtering that is difficult to bypass and
- daily electronic updating of the database requiring no customer input.
INDUSTRY BACKGROUND
Growth of the Internet
The internet has emerged as a critical global communications medium, enabling
millions of people to access and share information and conduct business
electronically. Industry analyst International Data Corporation estimates that
the number of Web users will grow from approximately 97 million worldwide in
1998 to approximately 320 million by the end of 2002. The rapidly increasing
volume of information available over the internet has contributed to the
phenomenal growth in the number of users and hours spent online. The internet
has become an invaluable tool for those who would otherwise not have access to
the rich data mine of information contained in libraries, databases and Websites
around the world. As a result, schools, libraries, homes, corporations and
affinity groups, such as churches or associations, increasingly are connecting
to, and encouraging their users to access, the internet.
In the United States, there are approximately 47 million public school K-12
students within 16,000 school districts and approximately 5 million private
school K-12 students. Estimates set the number of Canadian and European students
to be roughly equal to the number of students in the United States. Schools in
the United States are rapidly expanding their computer networks and adding
internet access with the help of a four year, $9 billion matching funds program
implemented by the Federal Communications Commission in January 1998. Both the
Clinton Administration and the Department of Education have announced long-term
goals to provide internet access to all students in the nation's public schools.
The Department of Education has recommended a target of one computer workstation
for every five students, up from one for about every 20 students currently.
We believe the home and business internet markets, both domestic and
international, present us with significant opportunities. The Annenberg Public
Policy Center estimates that 60% of United States households with children aged
8 to 17 have computers and 61% of those are connected to the internet.
International Data Corporation estimates that medium and large businesses will
account for 49 million internet users worldwide by the year 2000.
The Need for Filtering
The introduction and expanded use of the internet as an educational tool in the
classroom has prompted school board members, superintendents and teachers to
focus on protecting students from unsuitable internet content. Parents have also
become increasingly concerned about children's access to various types
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of content, ranging from pornography to bomb making instruction, among others.
Without an effective internet content filtering system in place, educators and
parents have had to choose between undesirable alternatives: prohibiting
internet access altogether or closely supervising each student's use of the
internet. Prohibiting internet access deprives students of the wealth of
beneficial information available on the internet, while supervision can waste an
enormous amount of teacher or parent time.
Corporations also face issues associated with unrestricted on-the-job access to
the internet, including productivity losses caused by employees spending large
amounts of time during the workday surfing the internet for personal reasons. In
addition, corporations are exposed to many potential liability issues relating
to the misuse of and unlawful distribution of internet-based content.
The Need for an Education Oriented Portal
The internet has the potential to be a rich educational resource for K-12
students. However, most existing internet portals are targeted to the needs of
an older audience and do not address the requirements of the growing school and
student internet communities. In addition, current search engines and portals
are not formatted to meet the specific educational needs and interests of these
communities. This makes it difficult and inefficient for students, parents and
teachers to incorporate the internet into the classroom and home.
The Development of Filtering
Early internet filtering products were based on the use of keywords, often
four-letter or slang expressions for sex or body parts. These products scan the
text of a Website and if designated keywords or phrases exist, access to the
particular Website or partial Website is blocked. Keyword blocking has
significant limitations in its ability to differentiate between acceptable and
potentially objectionable content, as it works on text only and relies on
scanning content without regard for context. For example, blocking anything with
"sex" in it blocks "Middlesex." It is impossible for a keyword blocking system
to block out all inappropriate content without simultaneously blocking a large
amount of useful information. In addition, much of the objectionable content on
the internet consists of graphics, some of which have no text to scan for
keywords.
In addition, most of the keyword filter products on the market are client-based
software products. Because the software must be installed and maintained on each
individual workstation that requires filtering, these systems have several
significant limitations:
- users can more easily circumvent the filtering programs,
- product installation and maintenance can be time consuming and expensive and
- database updates require user input.
Many server-based filtering solutions suffer from some of the same deficiencies
as client-based software products. Some have limited databases that may not be
updated frequently, some are keyword based, some require extensive
administrative oversight and some are not easy to adapt to larger network
environments.
In addition to keyword filtering, access to Websites can be blocked through
universal record locator lists and packet filtering. Universal record locator
blocking involves creating lists of Web addresses in a database, often
categorized as "allowed sites" or "blocked sites." Lists of blocked universal
record locators allow targeted content management by blocking only selected
portions of a given Website, but require frequent updating to ensure the list
remains current. By comparison, packet filtering blocks access to entire
internet servers, many of which contain multiple Websites with both valuable and
inappropriate material. The potential benefits of packet filtering in terms of
speed and simplicity may be outweighed by its lack of precision.
THE N2H2 SOLUTION
N2H2 is a leading provider of internet content filtering, serving schools, homes
and businesses. We develop, market and support technology services that make the
internet a safe and educational resource for
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K-12 students at school and at home. Our server-based internet filtering
solutions also enable businesses to increase employee productivity by limiting
the content employees can access on the internet. By using automated search
technology backed by human review to scan the internet for potentially
unsuitable material, we are able to offer our customers a significant
improvement over other internet filtering products. In addition, we offer
Searchopolis, which addresses the need for a content filtered, education focused
Web portal that is easy to navigate and provides communication tools to
students, teachers and parents.
Our Filtering Solution
In 1995, we introduced Bess, the first proxy server-based internet filtering
solution. We believe our system provides our customers the following key
benefits:
- Thorough and accurate content analysis. Our proprietary internet search
technology continuously scans the internet for content that fits into one or
more of 32 categories. Our staff of more than 15 full time and 58 part time
employees then reviews this content and places it in the appropriate
categories. Use of human review avoids overfiltering, which is often a
disadvantage of fully automated systems.
- Customer choice. We believe our proprietary search technology combined with
human review to categorize content enables our customers to effectively
tailor and control the Websites and pages they make available to their users.
Our system requires minimal customer oversight by a system administrator,
teacher or parent, while allowing our customers the flexibility to override
specific Website filtering, customize filtered categories, select time
schedules for various levels of filtering and grant password-based override
for authorized users.
- Protection of personal information. Our filtering solutions allow our
customers to protect students and children from inappropriate solicitations
of personal information. By identifying and categorizing Websites that seek
access to confidential or personal information about students and children or
their parents or families, we are able to address this growing concern about
internet access.
- Ease of installation and maintenance. Our proxy server-based filtering
solutions minimize customer need to support installation and maintenance of
equipment and software. Since our filtering product is network-based, there
is no need to install or maintain equipment or software at each user's
desktop. In addition, we provide full technical support to our customers for
our services.
- Difficult to bypass. Located on a customer's central network or at an
internet service provider, our server-based filtering is an integral part of
each internet access request. We believe, therefore, that it is virtually
impossible for the user to circumvent our filtering system.
- Continuous updating and caching. Our centrally managed system provides our
customers with a daily electronic update of our database of categorized
sites. As a result, our clients' filtering is kept current, reflecting
changes to sites on the internet on a near real-time basis. Our proxy servers
are also equipped with caching capabilities that can significantly speed
classroom access and save our customers critical telecommunication capacity
and expense.
Searchopolis: Our Education Portal to the Internet
Searchopolis combines the following key features:
- Safe search. Searchopolis includes our pioneering, proprietary filtering
technology operated in conjunction with Inktomi's search technology.
Searchopolis enables the user to find educational resources quickly and
navigate safely through the internet.
- Focused educational content. Teachers and students have limited class time to
access and use the internet. Searchopolis enables instant access to thousands
of Websites provided by our partner, Looksmart. These are organized by
subjects such as history, math and science and are supplemented with learning
tools such as a dictionary and news, sports and weather reports provided by
our partner, InfoSpace. By assembling educational content in one place,
making searches fast and relevant and
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avoiding the need for supervision, we believe Searchopolis provides a level
of effectiveness unmatched by any other educational Web portal.
- Communication tools. We are developing enhanced features for Searchopolis to
provide specialized communication tools for teachers, students and parents,
including:
-- access-controlled, filtered e-mail,
-- an easy-to-use calendar linking schools, teachers, students and parents in
local communities,
-- a Virtual Locker to store students' favorite internet sites, classroom
material and homework for access from the home, library or other locations
outside the classroom,
-- access to monitored chat rooms,
-- GradeChecker to provide parents, teachers and students internet access to
grades and other classroom information and
-- teacher tools, including a teacher calendar.
N2H2'S STRATEGY
Our goal is to expand our presence in the school, home and corporate markets and
to make Searchopolis the leading education oriented Web portal for K-12
students. We plan to achieve this goal through the following steps:
Aggressively expand our presence in schools. We plan to expand our education
user audience by building upon our reputation in the school market for
high-quality, effective internet content filtering. Part of our strategy for
doing this will be to make it easier for schools to purchase our services.
Today, schools are faced with many competing demands on their budgets, and we
believe they are open to proposals to assist them in meeting their educational
goals within their budgets. To more rapidly expand our filtering services and to
take advantage of advertising opportunities, we intend to offer alternate fee
structures to schools that allow us to sell sponsorship rights to advertisers
and to make Searchopolis the default search engine on these schools' networks.
Enhance content and communication features on Searchopolis. In June 1999, we
launched an enhanced Searchopolis portal which will feature specialized
communication tools customized for education, including access-controlled,
filtered e-mail, Virtual Locker, access to monitored chat rooms, GradeChecker
and a calendar. This new version of Searchopolis will also feature a directory
of useful Websites classified by educational topic and easier access to
reference tools, curriculum materials and other useful information. We plan to
continue adding content and communication features to Searchopolis in the future
and to build upon our existing agreements with Inktomi, Looksmart, InfoSpace and
Merriam-Webster, Incorporated.
Create advertising opportunities to reach the student market. We believe our
presence and continued growth in the education market will create a sizable
audience for advertisers trying to reach the 52 million public and private K-12
students in the United States. We expect to create the potential for high-value
advertising that will appeal to advertisers by differentiating students
according to school levels and geographic location.
Increase penetration of the home market. We believe parents familiar with Bess
and Searchopolis trust and value our services because we offer the content
filtering and search services used by their children's schools. We are expanding
the availability of our services to homes by making them available through
internet service providers. We have approximately 190 internet service provider
partners providing our services to over 150,000 homes in the United States and
are seeking additional relationships with internet service providers throughout
the United States and abroad. Internet service providers may choose to either
include our services in their customers' basic monthly internet access charge or
bill for it separately as an additional feature. We also target the home market
through affinity groups, such as churches and associations. These groups are
increasingly interested in filtered content tailored to their group's particular
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needs. For example, the Church of Jesus Christ of Latter Day Saints, the Mormon
Church, which has ten million members, uses our filtering search technology on
its Website.
Expand our presence in the corporate and international markets. We are pursuing
marketing alliances with companies in the United States and overseas to increase
our penetration of the corporate market. We are also increasing our direct sales
efforts in the corporate marketplace and we recently entered into an agreement
with Computer Sciences Corporation to provide company wide filtering of employee
internet use. In addition, we recently entered into a marketing alliance with
GTE Interactive to provide internet filtering for hotel guest rooms.
Increase sales and marketing efforts and build brand awareness. We plan to
substantially increase our direct sales activities and our marketing
expenditures to penetrate the school, home, international and business filtering
markets and increase the use of Searchopolis. We also plan to devote substantial
resources and continue to work with our advertising sales partner 24/7 Media to
increase our advertising sales volume. In addition, we have begun to implement a
major brand awareness and marketing campaign designed to deliver a focused
message to each of our targeted market segments.
Pursue additional strategic relationships. We intend to aggressively pursue
additional strategic relationships to expand our business in both the corporate
and international markets. We have customers in Canada, Australia, the United
Kingdom, Germany, Mexico, Chile, India and Bermuda and intend to expand
internationally by entering into additional overseas marketing relationships.
Where appropriate, we will consider the acquisition of businesses that can help
us provide specialized content or advanced service features.
SERVICES AND TECHNOLOGY
The N2H2 Filtering Service
We provide a complete filtering solution. Our filtering services enable our
school, library, corporate, home and other customers to limit access to
offensive or otherwise undesirable information on the internet. Our on-site
proxy servers are shipped to customers ready to install into their networks. Our
proxy servers are a combination of readily available computer hardware,
including a high capacity hard drive and a high-speed modem, purchased from
outside suppliers. We configure these servers with software developed by us that
enables them to perform their filtering functions. We also monitor and maintain
all the software and hardware components necessary to meet our customers'
filtering needs remotely from our Seattle, Washington network facility. Once a
customer notifies us that it has installed our proxy server, we can put it in
service in less than two hours. Our filtering solutions are comprised of three
main components:
- a proxy server infrastructure,
- our advanced internet content categorization system and
- tools for filter control and reporting.
Proxy server infrastructure: configurations and caching. Rather than installing
a filter on every workstation as is necessary with client-based products, our
solution uses a proxy server that is usually installed on the customer's
network. Every networked workstation uses our filtering solution to access the
internet.
Proxy server-based systems are secure and difficult to bypass because the proxy
server is installed directly in the network, thus making it virtually impossible
for users to access the internet without passing through this server. From a
customer's point of view, a proxy-based system is easy and economical to operate
because it can be managed by us from one central site. Our customers' systems
are monitored, maintained and kept updated primarily from our headquarters in
Seattle. The parameters that our clients use to control the filtering of their
internet content are stored by the proxy server located on their networks and
are based on information received from our central database of categorized
Websites. This information is updated and sent to our customers' proxy servers
daily. In addition, we also send system upgrades and enhancements to our
customers' proxy servers via the internet.
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We provide two proxy server configurations to our clients:
- On-site configuration. In most cases, we install our proxy server on the
customer's network. Internet requests are routed directly through these
servers for filtering. In larger networks, we may deploy multiple filtering
servers to assure adequate capacity, redundancy and backup. Our proxy server
can also be configured to include a caching feature that can significantly
increase internet access performance. Approximately 35% of universal resource
locators retrieved by servers in our system are retrieved from cache. This
caching feature substantially increases performance of most networks. Our
on-site configuration is most often used by medium to large sized schools,
school districts and state school systems. It is also used by internet
service providers and corporations, which are then able to provide filtered
internet services to their individual users, business customers or employees.
- Remote or redirect configuration. For smaller networks, we offer a "redirect"
service that enables multiple customers to share one regionally located proxy
server. All of the customer's internet requests are routed via the internet
to an off-site proxy server where the content is filtered and then returned
to the customer. Smaller schools and libraries have been the primary
customers of our redirect service. While this configuration is more
cost-effective for smaller networks, it does not operate at the same speed as
our on-site configuration because it requires multiple routing steps and
lacks caching.
Advanced Internet Content Categorization System
The filtering criteria available to our clients are based on our listing of
internet content categories. We believe we have created the most extensive and
accurate database and range of Website categories of any internet filtering
company. In our Website categorization process we employ a multi-step procedure
using automated search technology backed by human review to place internet
content into 32 distinct categories. Automated search is used to scan the
internet on a continuous basis to quickly identify Websites that potentially fit
into these categories. We employ a wide variety of techniques for this part of
our automated categorization process including keyword search and site
associations and linkages. Many of the techniques we use in our automated search
are proprietary and were developed by us. Once a Website has been identified as
fitting into one or more of our 32 categories, it is stored in a database and
prioritized for human review. Our categories and the material they cover are
summarized below:
<TABLE>
<S> <C>
- ---------------------------------------------------------------------------------------------------
CATEGORY MATERIAL
- ---------------------------------------------------------------------------------------------------
Adults Only Material labeled by its author or publisher as being
strictly for adults, such as, "Adults only" or "You must be
18 to visit this site."
- ---------------------------------------------------------------------------------------------------
Alcohol Advocates or promotes recreational use of alcohol.
- ---------------------------------------------------------------------------------------------------
Chat Chat sites or services that allow short messages to be sent
to others in real time.
- ---------------------------------------------------------------------------------------------------
Drugs Advocates or promotes recreational use of any controlled
substances. (See Illegal)
- ---------------------------------------------------------------------------------------------------
Employment Search Job-hunting and related employment resources.
- ---------------------------------------------------------------------------------------------------
Free Mail Sites that offer free Web e-mail accounts that can expose
users to unsuitable content delivered via e-mail file
attachments.
- ---------------------------------------------------------------------------------------------------
Free Home Pages Sites where home page space is offered for free. Individual
pages that have been reviewed by N2H2 on such sites are
removed from this category but filed under other categories
as appropriate.
- ---------------------------------------------------------------------------------------------------
Gambling Gambling services or information relevant to gambling.
- ---------------------------------------------------------------------------------------------------
Games Computer games and related information.
- ---------------------------------------------------------------------------------------------------
</TABLE>
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<TABLE>
<S> <C>
- ---------------------------------------------------------------------------------------------------
CATEGORY MATERIAL
- ---------------------------------------------------------------------------------------------------
Hate/Discrimination Advocates discrimination against others based on race,
religion, gender, nationality or sexual orientation.
- ---------------------------------------------------------------------------------------------------
Illegal Advocates or promotes illegal activities such as bomb
making, fraud and computer hacking.
- ---------------------------------------------------------------------------------------------------
Jokes Jokes and humor.
- ---------------------------------------------------------------------------------------------------
Lingerie Models in lingerie, except those classified as Nudity.
- ---------------------------------------------------------------------------------------------------
Message/Bulletin Boards Sites that permit semi-permanent messages to be posted and
read by others.
- ---------------------------------------------------------------------------------------------------
Murder/Suicide Information on committing murder or suicide and crime scene
photos.
- ---------------------------------------------------------------------------------------------------
News News and current events.
- ---------------------------------------------------------------------------------------------------
Nudity Naked or visible genitalia, buttocks, female breasts, etc.
- ---------------------------------------------------------------------------------------------------
Personal Information Sites that gather personal information, including name,
address and credit card number.
- ---------------------------------------------------------------------------------------------------
Personals Personal advertisements, including "mail order brides."
- ---------------------------------------------------------------------------------------------------
Pornography Material intended to be sexually arousing or erotic.
- ---------------------------------------------------------------------------------------------------
Profanity Crude, vulgar or obscene language or gestures.
- ---------------------------------------------------------------------------------------------------
Recreation/Entertainment Recreation and entertainment information, other than Games,
Jokes or Sports.
- ---------------------------------------------------------------------------------------------------
School Cheating Information Any site that promotes plagiarism or similar cheating among
students.
- ---------------------------------------------------------------------------------------------------
Sex Images or descriptions of sexual activity, sexual
merchandise or sexual fetishism.
- ---------------------------------------------------------------------------------------------------
Sports Sports information, especially professional sports.
- ---------------------------------------------------------------------------------------------------
Stocks Stock trading, stock quotes and stock market information.
- ---------------------------------------------------------------------------------------------------
Swimsuits Models in swimwear including fashion swimwear photos.
- ---------------------------------------------------------------------------------------------------
Tasteless/Gross Bodily functions, tasteless humor, graphic medical photos
and others.
- ---------------------------------------------------------------------------------------------------
Tobacco Advocating or promoting recreational use of tobacco.
- ---------------------------------------------------------------------------------------------------
Violence Graphic images or written descriptions of wanton violence or
grave injury, including graphically violent games.
- ---------------------------------------------------------------------------------------------------
Weapons Information on use of weapons, weapon collecting or weapon
making.
- ---------------------------------------------------------------------------------------------------
Not Categorized Material reviewed but not otherwise categorized.
- ---------------------------------------------------------------------------------------------------
</TABLE>
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In addition to these 32 categories, we allow for exceptions to our
categorizations to permit access to useful content that would otherwise be
filtered under another category including:
- educational material such as sex education and public health information that
may contain sex, nudity or violence,
- historically significant material that may contain sex or violence and
- medical information that may contain nudity.
Our customers have the flexibility to select which, if any, of the exceptions to
these categories they wish to enable.
Categorized sites are stored in a proprietary database located at our
headquarters. The contents of this database are continuously updated using both
human and automated review and reflect the introduction of new sites on the
internet and changes to sites we previously categorized. Each day, our customers
receive electronically an encrypted copy of the Website categorization
information stored in this database.
Tools for Filter Control and Reporting. We provide our clients with a broad
range of tools that they can use to control and modify their own filtering
criteria as well as to monitor the filtering activity on their networks. These
tools are accessed through a simple Web-based interface called the control
center. The control center is password protected and currently includes the
following features:
- Statistics reporting. Enables the system administrator to configure filtering
reports in single day, multiple day and historical formats. Summary data can
be displayed on Web pages, distributed by e-mail and exported to Excel
spreadsheets.
- Authorized users. Used to create special accounts for specific users that
need to temporarily turn off filtering at their workstations.
- Local URL customization. Allows the system administrator to block specific
universal record locators that are not categorized by our system or to allow
access to universal record locators that we have categorized.
- Request site review. Web-based e-mail form that customers can submit to us to
request review of a site for blocking or unblocking.
- Cache administration. Allows the user to control the storage criteria for
content in the proxy server cache.
- Cache-on-demand. Enables the administrator to set caching parameters.
Information preloaded in the proxy server cache can be retrieved
significantly faster, particularly when the customer's network is under heavy
use.
- Filter schedules. Used to schedule the time of day that specified filtering
rules will be put into effect. For example, filter schedules can be preset to
block game sites only during school hours.
- Filter builder. Customers use this feature to set up their own filtering
rules. They can begin this process by starting with one of our predefined
sets of rules or templates such as "Bess for Schools" or "Bess for Libraries"
and then make modifications as necessary.
- IP control. Enables the customer to define which workstations on their
network will have access to the proxy server for filtered internet service.
In addition, in the home and internet service provider market, parents have a
password-based override allowing them unfiltered internet access at any time.
Our central servers maintain a log of internet data retrieval requests and the
workstations that originated the request. However, this process does not provide
us with information about the identity of the individual originating the
request. In some instances, our clients may maintain information regarding the
identity of users on a particular workstation at a given time.
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Searchopolis: Our Education Portal to the Internet
Searchopolis is our comprehensive education portal, which includes our
pioneering filtering search technology. It incorporates what we believe to be
the most valuable educational resources found on the internet and combines with
them a number of other features that are important and interesting to middle and
high school students. The internet represents a huge educational resource, but
it is disorganized and a user must often invest significant time to locate
relevant material. By assembling educational content in one place, making
searches fast and relevant and minimizing the need for adult supervision,
Searchopolis makes the internet a more effective educational resource. We intend
to make Searchopolis attractive to middle and high school students, their
teachers and parents by providing extensive content and content arrangement
features as well as specialized communication services. We believe that as
students grow accustomed to using Searchopolis at school, they will also use it
more frequently at home and increasingly appreciate its many useful features.
Content and content management features. We operate Searchopolis in conjunction
with five partners including Infospace, LookSmart, Merriam-Webster, Tribune
Media Services and Inktomi that provide us with their proprietary content or
content management services under advertising revenue sharing agreements.
Educational content directory links. Searchopolis contains links to thousands of
sites categorized by class subject, including math, history, science,
literature, civics, health and business, among others. Numerous subcategories
allow the users to focus their research quickly. These links are organized and
provided by Looksmart.
Filtered search. Our filtering search technology is operated in conjunction with
Inktomi. This search tool prohibits the user from accessing a subset of our
database of categorized sites selected for school use. It also prevents
references to such sites, which often contain lurid descriptive words designed
to attract searches, from appearing on search result lists. Other search engines
include such references on search result lists even if access to the underlying
site is blocked by another filtering product or source.
Reference tools. Our reference tools include a dictionary provided by
Merriam-Webster, a calculator, a thesaurus, a spell checker, maps and yellow and
white page directories.
News, sports and weather. Up-to-date news, sports and weather information is
provided by InfoSpace.
General interest categories. Searchopolis also provides users with organized
links to sites in numerous general categories of interest to K-12 students.
These include such categories as automotive, finance, computers and internet,
home and family, sports and recreation, travel and vacation, shopping, hobbies
and entertainment. Searchopolis also provides daily features such as "today's
TV," "today's birthday" and "site of the day."
Tools to promote communication and community. We are enhancing Searchopolis to
provide specialized tools that promote communication for teachers, students and
parents including:
- Access-controlled filtered e-mail. Our proprietary e-mail service for K-12
students will provide a number of special features important to the school
environment. For instance, this service allows group sign-ups for all
students in a class or school, while providing filtering of content for
profanity and permitting the restriction of e-mail transmissions to specified
recipients. This service will give schools the ability to provide varying
levels of e-mail service to students of different ages. For example, a school
district might permit second graders to exchange e-mail only with other
second graders at the same school. Sixth graders might be allowed to exchange
e-mail with anyone at their school. Eleventh graders might be allowed to send
e-mail to anyone, including non-students.
- School calendar. Our easy-to-use proprietary calendar will link schools,
teachers, students and parents in local communities. The Web-based calendar
service will provide students with their own calendar as well as school and
class calendars that can be accessed by all school or class members. Teachers
and
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schools can maintain their own calendars and have selected items
automatically inserted into their students' calendars.
- Monitored chat rooms. Searchopolis will include access to monitored chat
rooms that provide students and children a safe environment to communicate
with friends and family.
- Virtual Locker. Students will be provided with their own Web-based Virtual
Locker in which they can store their favorite internet sites and homework for
later access from home, the library or other locations outside the classroom.
In many technologically advanced schools, students currently use as many as
four or five different computers per day. Our proprietary Virtual Locker
service will provide them with the ability to easily work on a variety of
different projects during the day without having to transfer files from one
computer to another.
- GradeChecker. GradeChecker will serve as our Web-based service allowing
parents, teachers and students direct and timely internet access to a
student's grades and other classroom information.
Searchopolis is available on the internet to anyone at www.searchopolis.com. Our
objective is to make Searchopolis the most used internet portal for students and
teachers. Although still under development, Searchopolis delivered approximately
2.0 million page views in May 1999. As we implement our alternate fee
structures, we believe Searchopolis will come to account for the majority of the
search traffic processed by our servers. Given the large potential volume of
internet traffic associated with K-12 students, we believe Searchopolis could
generate significant revenues from advertisers. We expect our education portal
to be a targeted, premium rate internet channel, which we will use to attract
major corporate advertisers.
SERVICE FEES
Our customers generally sign a 12-month subscription contract for our Bess
service that enables them to receive daily downloads of our categorized database
and to use our filtering and caching services. Our service delivery model is
similar for schools, internet service providers, libraries, businesses and other
customers. We also charge our customers an initial set-up or installation fee.
Both the set-up fee and the subscription rate depend upon the size and
complexity of the system installed and the expected volume of use. Subscriptions
have generally been renewed by our customers at the same price as the original
monthly subscription, without the installation charge. We believe we have a high
degree of customer satisfaction, which has resulted in an almost 100%
subscription renewal rate by our school customers during the several years that
we have offered Bess.
We plan to begin offering schools and libraries an important choice of alternate
fee structures effective for fall 1999, including an advertising-based
alternative with reduced rates or at no charge. Since schools and libraries have
limited budgets, our advertising-based fee structures will enable schools to use
their limited funding to rapidly increase the number of computer workstations in
their classrooms. At the time of subscription or renewal, customers may choose
to continue to pay our subscription fees or, alternatively, to pay reduced or no
subscription fees for our Bess filtering service in exchange for allowing
advertising and for using Searchopolis as their default search technology. We
believe many schools will choose to lower their subscription fees, which we
expect to result in accelerated market adoption of our filtering services. We
anticipate, but cannot guarantee, a substantial increase in new customers and
revenues from installations.
While our subscription revenues can be expected to decrease significantly, we
anticipate that they will be replaced, if not exceeded, by advertising revenues.
Historically, percentage increases in our subscription revenues have not kept
pace with the increased use of our systems. Our current fees are proportional to
the number of workstations on the customer network, not the volume of internet
traffic generated through those workstations. Our alternate fee structures, if
adopted by our customers, will allow our revenues to grow at a rate that
corresponds with the increased use of our services. We believe the combination
of our new services, our alternate fee structures, continuation of federal
matching funds programs and the
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increasing use of internet-based curriculum will drive increased use of our
internet filtering services in schools.
OPERATING INFRASTRUCTURE AND SECURITY
N2H2's operating infrastructure has been designed and implemented to support the
control and maintenance of thousands of servers handling millions of user
requests per day. Our systems can be easily configured and expanded to
accommodate a wide range of bandwidth and other performance requirements. For
example, our systems are currently used by a number of small organizations with
less than 100 internet users as well as large state or county school systems.
Our proxy servers use standard hardware that is easily obtained from commercial
sources and equipped with our proprietary software. Our proxy servers are
compatible with a broad range of network platforms including Microsoft, Sun,
IBM, Apple, Macintosh and Novell. Our filtering servers run on the Linux
operating system and use custom-developed filtering proxy server software.
Internal servers run on Linux, Sun Solaris and Microsoft NT operating systems
and use custom-developed software in addition to Apache, Microsoft SQL Server
and Sybase Adaptive Server Enterprise.
Key attributes of our operating infrastructure include the ability to support
customer growth as well as performance, security and service requirements. We
maintain most of our proxy servers on our customers' premises. We also maintain
some proxy servers in our Seattle data center, and Exodus maintains additional
servers for us at their location. We house all of our critical infrastructure
servers in our Seattle data center. Our operations are dependent upon each
location's ability to protect its systems against damage from fire, earthquake,
power loss, telecommunications failure or physical break-ins. Exodus provides
comprehensive facilities management services for some of our centralized
servers, including human and technical monitoring of proxy servers 24 hours per
day, seven days per week. Exodus' facility is powered by multiple
uninterruptible power supplies. Any disruption in the internet access provided
by Exodus could seriously harm our business, results of operations and financial
condition.
All of the information required to duplicate a customer's filtering server is
stored in a database in our Seattle data center. We back up on a daily basis any
information in this database that may change on a server in the field. This
process allows us to reconstruct any data that is lost by a server in the event
of catastrophic failure or other disaster.
Our internal servers are protected behind firewalls for security purposes and do
not allow outside access at the operating system level except via special secure
channels. Access to our remote servers requires a connection originating from
one of two servers in our data center which must be accompanied by a 1024 bit
encryption key. Our servers use a highly secure operating system that is
difficult to override or bypass. Our security personnel follow CERT, BugTraq and
other security-related forums closely to ensure that any new threats are
identified and dealt with immediately. However, we cannot assure you that our
operating infrastructure will not be affected by computer viruses, electronic
break-ins or other similar disruptions.
CUSTOMERS
We provide filtering services to a customer base that includes the following:
Schools. Our school customers range from single schools to statewide systems.
Customers with thousands of workstations and multiple N2H2 servers include
Macomb School District in Michigan, Merrimack Education Center in the Boston
area, statewide networks for Ohio, Tennessee, Maine, Oklahoma and Wisconsin,
plus Calgary and the Dufferin-Peel Roman Catholic school systems in Canada. Over
7.3 million students in approximately 8,000 schools now use Bess. Our customers
are located in 47 states, Canada, Australia, United Kingdom, Germany, Chile,
Mexico, India and Bermuda. In May 1999, our customers used our filtering servers
to receive approximately 349 million internet page views.
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Homes. We currently provide our filtering services to homes through
approximately 190 internet service providers. To date, over 150,000 homes have
elected to use our services. We recently entered the home market and we believe
our services will be used in more homes in the future. The charge for our
filtering service is typically added to the customer's monthly bill from its
internet service provider. Internet service providers may also serve as
re-sellers of our services to small businesses and schools.
Affinity Groups. We provide our core technology for filtering, filtered search
and portal development to affinity groups, including the Mormon Church. Affinity
groups purchase our filtering services for their own members. They also purchase
from us filtered search services to include on their own affinity group portal.
Corporate and International. Corporate and international customers are a small
but growing part of our customer base. We provide services to customers in
Canada, Australia, the United Kingdom, Germany, Chile, India, Mexico and
Bermuda. As corporate managers become increasingly concerned about productivity
and liability issues related to employee internet usage, we believe the
corporate market will present us with significant opportunities.
SALES AND MARKETING
Sales to Customers
Our sales division consists of 21 sales representatives and support staff,
organized into four direct sales groups, a post-sale customer support group and
an administrative support team. Each direct sales team is dedicated to one of
our four main sales channels.
- Direct education channel. The direct education sales group is our largest and
is divided into three areas, each focusing on customers of particular sizes
and needs.
-- Our "key accounts" group focuses on sales of all our services to the
large educational service districts or statewide school networks.
-- Our mid-tier education sales group sells our filtering and caching
proxy services, rating list subscriptions and search services to
larger schools and educational service districts that operate their
own networks, generally serving between 200 and 10,000 workstations.
-- Finally, our small customer sales team sells our cache, filter and
search services on a redirect basis to smaller schools, educational
service districts and libraries that have anywhere from one to 200
workstations.
- ISP channel. We often gain regional internet service provider business due to
local internet service provider activity within the education channel. As
such, our education sales team manages the smaller to mid-size regional
internet service providers as part of its educational sales territory. Our
internet service provider sales team concentrates on selling our filtering
and caching proxy servers, rating list subscriptions and filtering search
technology to regional and larger internet service providers throughout the
world. We have two senior sales managers dedicated to developing
relationships with key national and international internet service providers.
- Corporate and international markets. We have two sales representatives
dedicated to developing sales in the corporate and international markets. We
anticipate increased demand for our services and products as we expand our
strategic alliances both domestically and abroad.
- Reseller program. In addition to our direct sales groups, we have a group of
technical sales professionals referred to as resellers dedicated to expanding
sales of our caching proxy servers and filtering services through a growing
list of third-party resellers. We currently have ten resellers domestically
who operate as sales agents as well as four located in the United Kingdom and
Australia who provide both sales and customer support services. Our target
reseller customers are established internet service providers with large
existing education customer bases and sales agents with access to end users
that we cannot easily reach.
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Advertising Sales
Although we have only recently begun receiving advertising revenues, we are
aggressively pursuing relationships with advertisers trying to reach K-12
students, particularly those in the 10-year to 18-year age group. This group,
which constitutes the younger part of the 10 to 24 year old age group known in
the advertising industry as "Generation Y", has become the subject of increasing
focus among advertisers. It has been estimated that Generation Y represents more
than $150 billion in disposable income in the United States annually. We believe
that a higher percentage of people in this age group have been introduced to
computers at an earlier age than any previous generation.
Internet advertising is now typically conducted through the use of
"click-through" advertising banners, by which users can access more information
about an advertised product or service by clicking on the banner. Contracts for
banner advertising are typically short-term in nature, and revenues are based
upon the number of page views, referred to as user impressions. This makes it
difficult to forecast revenues receivable under internet advertising contracts.
We plan to address this uncertainty by entering into long-term "sponsorship"
arrangements with advertisers that would call for a fixed fee for a specified
time period although we have not presently entered into any such agreements.
We intend to use part of the proceeds of this offering to retain marketing
consultants with substantial advertising industry experience. We recently began
receiving sponsorship and advertising-based revenue through 24/7 Media, our
advertising partner, and we plan to expand this relationship. These efforts are
intended to increase our visibility in the advertising and corporate communities
and to help us gain access to those individuals at major corporations with
decision-making authority over advertising expenditures. Currently, all our
advertising is provided by 24/7 Media. Our advertising revenues from 24/7 Media
are generated based on the number of advertising impressions made on
Searchopolis. We are also currently targeting advertisers in the following
industries:
- food and beverage,
- apparel,
- sporting goods,
- entertainment,
- consumer electronics and
- automotive.
We believe that companies in each of these industries are looking for new ways
to reach the Generation Y audience.
We intend to pursue sponsorship arrangements that would differ from the typical
internet banner advertising deals to support broad marketing objectives,
including brand awareness, product introductions and online research.
Marketing
Our marketing department currently consists of six people. We hired a marketing
staff member in June 1999, and we are actively seeking to expand the size of
this group. We also plan to add a full-time trade show manager, as participation
in trade shows is an important element of our marketing strategy. See
"Management's Discussion and Analysis of Financial Conditions and Results of
Operations -- Overview -- Sales and Marketing" for a discussion of our
anticipated costs in expanding sales and marketing efforts.
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We advertise and market Bess, Searchopolis and our other services through a
variety of activities, including:
- Trade shows. We have increased our visibility at major educational technology
events in 1999, including those held in Atlantic City, Orlando, Austin,
Seattle and Baltimore. Management believes that trade shows have historically
generated significant sales leads.
- Print advertising. We will continue to maintain a steady presence in key
education technology journals, including eSchool News, Curriculum
Administrator and Technology & Learning. We believe that these publications
are regularly reviewed nationwide by education administrators responsible for
technology budgets and spending decisions.
- Direct mail. We regularly contact school administrators through direct mail.
In the current school year, we have twice sent over 13,000 product brochures
to education technology specialists throughout the country.
- Online marketing. Our Website, www.n2h2.com, provides information about our
services, facilitates communication with our current and potential customers
and will provide links to Websites of our strategic partners. In addition, we
include links to Searchopolis in our Bess filtering services.
We market Searchopolis to existing customers through:
- a link located on the trailer appearing at the bottom of each page viewed
through Bess,
- requests for Websites which are blocked by Bess return the user directly to
Searchopolis and
- our new alternate fee structures provide incentives through price discounts
for encouraging use of Searchopolis.
STRATEGIC RELATIONSHIPS
We have developed and intend to continue to develop strategic relationships to
offer services and products to a larger customer base than can be reached
through our direct sales efforts. We have a strategic relationship with Inktomi
for the operation of our filtering search technology. Under a Search Engine
Services Agreement dated January 19, 1998, Inktomi provides us with search
engine services that, combined with our filtering technology and database of
categorized Websites, form the basis of our filtering search technology. This
agreement has a three-year term and is terminable only upon a material breach of
either party which is not uncured within thirty days or in the event either
party becomes insolvent or bankrupt.
In addition, we also have strategic content and marketing relationships with
other companies, including Looksmart, WinStar Communications, Fortres Grand and
Netwave Technologies. Our agreements with Looksmart and InfoSpace have been
instrumental in assisting us in the assembly and presentation of educational
content through Searchopolis. We collaborate with a number of companies, such as
WinStar Communications and Fortres Grand Corporation, to make our internet
filtering services available to an expanding customer base through redirect
arrangements. In other relationships, we provide filtering and caching services
to internet browsers, such as NetWave's children's browser. Our plans for
increasing our corporate and international presence depend on our success in
establishing additional strategic relationships.
CUSTOMER SERVICE AND SUPPORT
We believe our high customer retention rate is evidence of our excellent
reputation for customer service. We respond to approximately 1,200 e-mails each
school day from our customers through a staff of eight reviewers dedicated
solely to that purpose. While some are from wishful students with requests such
as
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"Please unblock Playboy.com!", most provide useful feedback that helps us refine
the accuracy and relevance of our categorization determinations.
COMPETITION
We face a large number of competitors in the internet filtering industry. Some
of the competing products, including NetNanny, SurfWatch and CyberPatrol, are
primarily client-based products that are sold directly to the end user. While we
believe that our comprehensive filtering services provide a solution superior to
these products, these products have generated significant name recognition among
parents and represent a significant competitive force in the residential
marketplace.
In addition, we have competitors that feature proxy server-based filtering
solutions using technology similar to ours, such as NetPartners Internet
Solutions, Inc.'s WebSENSE, Logon Data Corporation's X-Stop and Unified Research
Laboratories, Inc.'s I-Gear. We believe, however, that none of these products is
backed with the same level of customer support and services as ours and that
their filtering is accomplished with less precision than ours.
Searchopolis, we believe, will represent the first widely available integrated
educational internet portal targeting K-12 students, and our alternate fee
structures will give schools the choice of paying our recurring subscriber fees
or receiving our subscription-based service at reduced rates or without charge
in exchange for allowing us to sell sponsorship rights to advertisers. We
believe these alternate fee structures should give us a significant competitive
advantage. However, a competitor with greater financial and human resources than
ours could introduce a competing product to the same market fairly quickly.
Accordingly, a significant component of our strategy will be to penetrate this
market rapidly, before competing products are able to gain significant market
share, name recognition or credibility. In particular, our potential competitors
include Web retrieval and other Web portal companies such as Excite, Infoseek,
Lycos, Yahoo! and Netscape, as well as Websites targeted to educational and
family-oriented interests such as Disney.com and AOL.com.
INTELLECTUAL PROPERTY
Intellectual property is critical to our success, and we rely upon trademark,
copyright and trade secret laws in the United States and other jurisdictions to
protect our proprietary technology and brands. N2H2 and Bess are registered
United States trademarks. We have also applied to register Searchopolis and
Virtual Locker as trademarks. These trademark applications may not be granted.
In addition, any of our trademarks may be challenged by others or invalidated
through administrative process or litigation. None of our technology is
patented, and we have no patent applications pending. Our proprietary search
technology is protected by United States trade secret and copyright law. We own
and operate the servers that provide our filtering services. We protect our
proprietary rights through the use of intellectual property agreements with
employees and consultants which cover confidentiality, nondisclosure and
assignment of invention matters. Some of our former employees and consultants
who may have had access to our proprietary information have not entered into
these intellectual property agreements, although we believe that all
intellectual property that is material to our business is covered by signed
agreements. If we are wrong in this assessment, our business could be seriously
harmed.
Trademark, copyright and trade secret protection may not be available to us in
every country in which our services are available. The laws of some foreign
countries may not be as protective of intellectual property rights as United
States laws, and mechanisms for enforcement of intellectual property rights may
be inadequate. Despite our efforts to protect our proprietary rights,
unauthorized parties may attempt to obtain, copy and use our proprietary
technology.
REGULATORY AND LEGISLATIVE ISSUES
As use of the internet has become more prevalent and various negative issues
associated with the internet have received increasing amounts of publicity,
there has been a correspondingly greater amount of
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governmental attention directed to the internet in the United States Congress
and elsewhere. While various pieces of legislation regulating different aspects
of the internet and internet-related activity have been proposed, to date there
has been no legislation enacted which places any direct and substantial
regulatory burden on N2H2. Nonetheless, we anticipate further attempts to
regulate internet-related activity, some of which may impose substantial burdens
on our ability to do business.
We have never been party to a lawsuit regarding users acquiring inappropriate
content through our system. Management believes this is unlikely in the future,
partly because of the protections provided under Section 509 of the
Telecommunications Act of 1996 for organizations that provide filtering tools or
employ them. Our customer contracts do not provide for a guaranteed level of
filtering performance, and we do not intend to offer guarantees in the future.
The United States Congress recently enacted the Children's Online Privacy
Protection Act of 1998. The principal provisions of the law become effective on
the later of (1) April 21, 2000, and (2) the date on which the Federal Trade
Commission issues a first ruling on applications for safe harbor treatment under
the Act if the Commission does not rule on the first such application by October
21, 1999, but in no case later than April 21, 2001. This act generally:
- makes it unlawful for an operator of a Website or online service directed to
children under age 13, and any operator that has actual knowledge that it is
collecting personal information from such a child, to collect personal
information from the child without having obtained verifiable parental
consent and
- prohibits conditioning the participation of a child under age 13 in a game,
the offering of a prize or another activity on the child disclosing more
personal information than is reasonably necessary to participate in such
activity.
We do not believe that this Act will have a significant impact on our business.
LEGAL MATTERS
On June 25, 1999, Spyglass, Inc. filed a patent infringement lawsuit against us
in United States District Court for the Northern District of California. The
suit alleges that the making, use and sale of our internet filtering systems
infringes a United States patent held by Spyglass. The suit seeks unspecified
damages (including treble damages), preliminary and final injunctions against
further alleged infringement and attorneys' fees. We believe that we do not
infringe any of the Spyglass patent claims. This belief is based upon our
investigation to date and upon an opinion of Seed & Berry LLP, our patent
counsel. Accordingly, we intend to vigorously defend ourselves in this lawsuit.
Since the lawsuit was recently filed and discovery has not yet commenced, we are
not presently able to estimate the likelihood of an adverse result or the range
of possible loss relating to this matter. In the event of an adverse result, we
could be required to do one or more of the following:
- pay substantial damages, including treble damages,
- permanently cease use of any infringing technology,
- obtain a license for the technology or expend significant resources to
develop noninfringing technology and
- attempt to redesign our filtering services to avoid the infringment or
to develop noninfringing technology.
Any limitation on our ability to market our services or products or the costs
and potential delays associated with redesigning our services or products would
seriously harm our business, financial condition and results of operation.
On May 3, 1999, NextGen Development Corporation filed a complaint in the
Superior Court of California, Orange County, against us, Hammock Consulting
Services, Inc. and other parties. On May 4, 1999, we removed the lawsuit to
United States District Court for the Central District of California. The
complaint
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alleges that the calendar product we hired Hammock to develop for us uses
proprietary information belonging to NextGen. The complaint seeks, among other
things, a preliminary injunction prohibiting us from marketing our portal,
Searchopolis, because it allegedly includes the calendar product in question as
one of its screen tools. Our calendar is still under development, and we do not
believe that it uses any proprietary information of NextGen. We intend to
vigorously defend ourselves in this lawsuit. In the meantime, we have entered
into a mutual non-disclosure agreement with NextGen and Hammock in order to
pursue a resolution of this matter. Under a separate indemnity agreement entered
into in May 1999, we have agreed to indemnify Hammock against any costs,
expenses or liabilities relating to this matter. At present, we believe it is
only remotely likely that the NextGen lawsuit will have a material impact on us.
If NextGen is successful in obtaining a preliminary injunction, we believe we
will be able to continue marketing Searchopolis without a calendar or with an
alternate calendar product.
EMPLOYEES
As of May 31, 1999, we had 154 full-time and part-time employees, including 27
in sales and marketing, 24 in technology and product development, 16 in
operations and 14 in management, finance and administration. In addition, we had
15 full-time and 58 part-time Website reviewers. As necessary, we supplement our
regular employees with temporary and contract personnel.
FACILITIES
Our principal place of business is located in Seattle, Washington, where we
currently lease approximately 21,000 square feet of office space. Beginning
November 1, 1999 we intend to increase our total leased space to approximately
30,000 square feet at the same location. Our principal lease, covering
approximately 17,000 square feet, expires in November 2004 and includes during
the term a right of first refusal on an additional approximately 13,000 square
feet of space at market rates. We recently delivered notice to our landlord of
our intent to exercise this right of first refusal, and we anticipate
negotiations with our landlord will proceed in the upcoming months. We are
leasing approximately 4,000 additional square feet on a month-to-month basis
through December 31, 1999. Given our anticipated growth, we may need to find
suitable space in addition to the increased space available under the right of
first refusal, but we believe space will be available as needed on commercially
reasonable terms.
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MANAGEMENT
EXECUTIVE OFFICERS, DIRECTORS AND KEY EMPLOYEES
The following table gives some information regarding our executive officers,
directors and key employees as of July 7, 1999:
<TABLE>
<CAPTION>
NAME AGE POSITION
---- --- --------
<S> <C> <C>
Peter H. Nickerson......................... 47 President, Chief Executive Officer and
Chairman of the Board of Directors
John F. Duncan............................. 56 Vice President -- Chief Financial Officer,
Secretary and Treasurer
Kevin E. Fink.............................. 28 Vice President -- Chief Technology Officer
B. Patrick Murphy.......................... 40 Vice President -- Sales
Peter H. Keane............................. 42 Vice President -- Advertising
James J. O'Halloran........................ 41 Vice President -- Marketing
Peter F. Hodgson........................... 41 European Operations Director
Hollis R. Hill............................. 49 Director
Mark A. Segale............................. 39 Director
Richard R. Rowe............................ 66 Proposed Director
</TABLE>
Peter H. Nickerson has served as President and Chairman of the board of
directors since founding N2H2 in 1995. Since 1986, Mr. Nickerson has been a
principal of Nickerson & Associates, an econometric and data management
consulting company. He holds a Ph.D. in Economics from the University of
Washington and prior to forming N2H2 in 1995 he was a professor of economics in
the Albers School of Business at Seattle University. Mr. Nickerson is married to
Ms. Hill.
John F. Duncan joined N2H2 in April 1997 and serves as our Vice
President -- Chief Financial Officer. He also serves as our corporate Secretary
and Treasurer. From July 1996 to March 1997, Mr. Duncan was employed as a
finance and business strategy consultant to various internet related companies.
Mr. Duncan served as President and Chief Executive Officer of Stream Line, Inc.
a manufacturer of fly fishing equipment from 1991 to 1996. From 1986 to 1991, he
served as Chief Financial Officer of Tom Software, a developer of fourth
generation languages and accounting applications. He has also served as Chief
Financial Officer for The Myers Group from 1984 to 1986. He has an M.B.A. in
finance from the Wharton School of the University of Pennsylvania.
Kevin E. Fink co-founded N2H2 in 1995 and serves as our Vice President -- Chief
Technology Officer. Mr. Fink has been the primary technology architect of our
services and products. Mr. Fink was the sole proprietor of KF Consulting from
September 1995 to December 1995. From February 1995 to September 1995, Mr. Fink
was director of management information services at Virtual Broadcast Networks.
He received an M.S. in Electrical Engineering from the University of Washington
in 1994 and a B.S. in Engineering from Harvey Mudd College.
B. Patrick Murphy joined N2H2 in April 1998 and serves as our Vice
President -- Sales. Mr. Murphy is responsible for managing all sales programs.
From 1996 to 1997, Mr. Murphy was a Divisional Director for AEI Music Network
and managed a network of 200 sales and service partners for this Seattle-based
commercial music provider. His experience includes 13 years in the application
software and systems integration field, including nine years as Sales Manager,
Vice President and Partner with Benchmark Systems, Inc. from 1987 to 1996. Mr.
Murphy holds a B.A. in Economics and an M.B.A. in finance from Washington State
University.
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Peter H. Keane joined N2H2 in May 1998 and serves as our Vice
President -- Advertising. Mr. Keane is responsible for developing the
advertising sales strategy for our internet filtering services. He served as
Vice President of Corporate Development for Hyperbole Studios from 1996 to 1998
and as the Director of Advertising Revenue for Kidstar from 1993 to 1996. Prior
to that he held various advertising sales and management positions with the
Hearst Corporation. Mr. Keane has a B.A. in pre-law studies from Arizona State
University where he also completed M.B.A. coursework.
James J. O'Halloran joined N2H2 in June 1998 and serves as our Vice
President -- Marketing. Mr. O'Halloran has 20 years of sales and marketing
experience with various firms including technology companies. He was Director of
Education Marketing at Edmark Corporation from 1997 to 1998. He was Vice
President of Sales and Marketing for Videodiscovery from 1994 to 1997. Mr.
O'Halloran holds a B.S. in business administration from Pennsylvania State
University and an M.B.A from the University of Washington.
Peter F. Hodgson joined N2H2 in June 1999, and serves as our European Operations
Director. From June 1996 to April 1999, Mr. Hodgson was an internet consultant
and advisor and from January 1995 to June 1996, he was a consultant to
Computercall Ltd. From November 1989 to December 1994, he served as Chief
Executive Officer of Cellephone Group, PLC, a cellular service provider. Prior
to that, he held positions primarily related to sales and marketing, including
six years spent with British Telecom.
Hollis R. Hill has served as a director of ours since October 1997. Ms. Hill, an
attorney, was of counsel with the firm of Frank & Rosen from 1992 to 1997 and is
presently self-employed as a trial advocacy teacher for the National Institute
of Trial Advocacy. Ms. Hill is also an adjunct faculty member at the University
of Washington School of Law. Ms. Hill received her J.D. from the Northwestern
School of Law in Chicago and her B.A. in Independent Studies from Vassar
College. Ms. Hill is married to Mr. Nickerson.
Mark A. Segale has served as a director of ours since December 1998. Mr. Segale
has served as Vice President of MAS Resources, Inc. since 1984 and as President
of Seattle Tractor Parts and Equipment, Inc. from 1979 to the present. Mr.
Segale received his B.A. in business administration from Seattle University in
1981.
Richard R. Rowe Ph.D. will join N2H2 as a Director prior to closing of the
offering. Dr. Rowe is the founder of RoweCom (Nasdaq "ROWE"), which provides
internet-based magazine, newspaper, journal and other printed material
purchasing and managing solutions. Dr. Rowe has served as RoweCom's Chairman of
the Board, President and Chief Executive Officer since 1994. Prior to founding
RoweCom, he was the President and Chief Executive Officer of the Faxon Company
from 1980 to 1993, a leading library subscription agency. Prior to joining
Faxon, Dr. Rowe was an Associate Dean of the Harvard Graduate School of
Education, Director of Harvard's interfaculty Doctoral Program in Clinical
Psychology and Public Practice, and Director of the Cambridge office of the
American Institutes for Research. Dr. Rowe serves on the Board of Directors of
RoweCom, Inc, the MIT Press, the Massachusetts Business Alliance for Education
and Educators for Social Responsibility. He also served for five years as a
member of the Massachusetts State Board of Education where he chaired the
Education Reform task force. Dr. Rowe holds a Ph.D. in clinical psychology from
Columbia University.
BOARD COMPOSITION
Our board will consist of four directors and, under our amended bylaws, may be
increased or decreased by board or shareholder action. At some time after
closing of this offering, we intend to increase the number of directors to five.
Prior to closing of this offering, our restated articles of incorporation will
provide for the division of our board of directors into three classes, as nearly
equal in number as possible. Hollis R. Hill and Richard R. Rowe will be the
initial Class I directors, Mark A. Segale will be the initial Class II director
and Peter H. Nickerson will be the initial Class III Director. Initially, the
Class I directors will serve for a
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one-year term, Class II directors will serve for a two-year term and Class III
directors will serve for a three-year term. One class of director will be
elected each year thereafter by our shareholders. Directors may be removed only
for cause. Because this system of electing and removing directors generally
makes it more difficult for shareholders to replace a majority of the board of
directors, it may tend to discourage a third party from making a tender offer or
otherwise attempting to gain control of N2H2 and may maintain the incumbency of
the board of directors.
COMMITTEES OF THE BOARD OF DIRECTORS
Our compensation committee will consist of Richard R. Rowe and Mark A. Segale.
Our compensation committee will review and approve the compensation and benefits
for our executive officers and grants of stock options under our stock option
plans and will make recommendations to the board of directors regarding such
matters.
Our audit committee will consist of Richard R. Rowe and Mark A. Segale. Our
audit committee will make recommendations to the board of directors regarding
the selection of independent auditors, will review the results and scope of the
audit and other services provided by our independent auditors and will review
and evaluate our audit and accounting control functions.
DIRECTOR COMPENSATION
We intend to pay each of our nonemployee directors $1,000 for each board of
directors meeting attended in person, $500 for each board meeting attended
telephonically, $500 for each committee meeting attended in person and $250 for
each committee meeting attended telephonically. We also intend to reimburse our
nonemployee directors for reasonable expenses they incur in attending meetings
of the board and its committees. Our nonemployee directors are also eligible to
receive stock options under the 1999 Nonemployee Director Stock Option Plan. See
"Management -- 1999 Nonemployee Director Stock Option Plan," for a description
of these stock options.
DIRECTOR AND OFFICER INDEMNIFICATION AND LIABILITY
Our restated articles of incorporation include a provision that limits the
liability of directors to the fullest extent permitted by the Washington
Business Corporation Act as it currently exists or as it may be amended in the
future. Consequently, subject to the Washington Business Corporation Act, no
director will be personally liable to us or our shareholders for monetary
damages resulting from his or her conduct as a director of ours, except
liability for:
- acts or omissions involving intentional misconduct or knowing violations of
law,
- unlawful distributions or
- transactions from which the director personally receives a benefit in money,
property or services to which the director is not legally entitled.
The restated articles of incorporation also provide that we will indemnify any
individual made a party to a proceeding because that individual is or was a
director of ours. We will also advance or reimburse reasonable expenses incurred
by that individual prior to the final disposition of the proceeding to the
fullest extent permitted by applicable law. No repeal of the restated articles
of incorporation or modification of them will adversely affect any right of a
director of ours who is or was a director at the time of the repeal or
modification. To the extent the provisions of the restated articles of
incorporation provide for indemnification of directors for liabilities arising
under the Securities Act of 1933, those provisions are, in the opinion of the
Securities and Exchange Commission, against public policy as expressed in the
Securities Act and unenforceable. We have purchased and maintain director and
officer liability insurance
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coverage under which our directors and officers may be indemnified against any
liability they may incur for serving as our directors and officers.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
Our compensation committee will consist of two outside directors. We anticipate
that no interlocking relationship will exist between the compensation committee
and the board of directors or compensation committee of any other company, nor
will any such relationship have existed in the past.
EXECUTIVE COMPENSATION
The following table provides information on the compensation awarded to, earned
by or paid for services rendered to us in all capacities during the fiscal year
ended September 30, 1998, by our chief executive officer and the other most
highly compensated executive officers who were serving as executive officers as
of September 30, 1998 and whose compensation was in excess of $100,000 in the
fiscal year ended September 30, 1998, collectively, our named executive
officers.
SUMMARY COMPENSATION TABLE
<TABLE>
<CAPTION>
NAME AND PRINCIPAL POSITION SALARY($) BONUS($)
--------------------------- --------- --------
<S> <C> <C>
Peter H. Nickerson, President, Chief Executive Officer and
Chairman of the Board of Directors........................ $132,500 $13,898
John F. Duncan, Vice President -- Chief Financial Officer,
Secretary and Treasurer................................... 84,542 29,858
Kevin E. Fink, Vice President -- Chief Technology Officer... 88,333 40,000
</TABLE>
No options were granted to the named executives in the last fiscal year.
AGGREGATED OPTION EXERCISES IN THE FISCAL YEAR ENDED SEPTEMBER 30, 1998 AND
FISCAL YEAR END OPTION VALUES
The following table contains information concerning the options exercised by the
named executive officers in the fiscal year ended September 30, 1998 and the
year end number and value of unexercised options with respect to each of the
named executive officers. There were no stock appreciation rights granted or
exercised during 1998, and none were outstanding as of September 30, 1998. The
calculation of the value of unexercised in-the-money options at fiscal year end
in the following table is based on the assumed initial public offering price of
$11.00 per share, less the corresponding exercise price of the options,
multiplied by the number of shares underlying the options. See
"Management -- 1997 and 1999 Stock Option Plans" for a discussion of the board's
methodology for determining the fair market value of the common stock at the
time of the grants.
<TABLE>
<CAPTION>
NUMBER OF SECURITIES
UNDERLYING UNEXERCISED VALUE OF UNEXERCISED
OPTIONS AT FISCAL IN-THE-MONEY OPTIONS AT
SHARES VALUE YEAR END(#) FISCAL YEAR END($)
ACQUIRED REALIZED --------------------------- ---------------------------
NAME ON EXERCISE ($) EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
---- ----------- -------- ----------- ------------- ----------- -------------
<S> <C> <C> <C> <C> <C> <C>
Peter H. Nickerson........... 374,062 $26,505 -- -- -- --
John F. Duncan............... -- -- 149,625 224,437 $1,618,524 $2,427,780
Kevin E. Fink................ -- -- -- -- -- --
</TABLE>
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EMPLOYMENT AGREEMENTS
We have entered into employment agreements with several of our officers.
Following is a summary of the material terms and conditions of these agreements.
The summary is subject to the detailed provisions of the agreements attached as
exhibits to this registration statement.
Peter H. Nickerson, John F. Duncan and Kevin E. Fink, each of whom is referred
to as an officer, entered into employment agreements with us on May 10, 1999.
Mr. Nickerson's employment agreement provides for an initial two year term, and
the agreements with Messrs. Duncan and Fink provide for 18 month terms. All
three agreements are renewable indefinitely subject to the termination
provisions described below. The compensation for each officer is as follows:
- Mr. Nickerson will be paid an annual base salary of $225,000,
- Mr. Duncan will be paid an annual base salary of $150,000 and
- Mr. Fink will be paid an annual base salary of $150,000.
The officers' base salaries will increase October 1 of each year by 10% if we
achieved a 100% increase in revenues for the preceding year. Messrs. Nickerson,
Duncan and Fink will receive quarterly bonuses as a percentage of revenues equal
to 2.25%, 1.5% and 1.5%, respectively, of the growth in our total quarterly
revenues compared to the same quarter in the prior year, with a maximum each
fiscal year equal to 70% of the officer's base salary. In addition, each officer
is entitled to reimbursement for reasonable and documented business expenses.
Each officer's employment agreement terminates on the officer's death or
disability or for cause, where cause means:
- a failure or refusal to perform specific duties under the employment
agreement which remains uncured,
- willful misappropriation of funds,
- excessive drug or alcohol use,
- conviction of a felony or
- any willful or intentional act in disregard of our interests.
If an officer's employment agreement is terminated due to death or disability,
we will continue to pay the officer's base salary for a minimum of 12 months.
Upon termination for cause or voluntarily by the officer without good reason, we
will pay the officer's base salary and bonus, if any, only through the date of
termination.
Mr. Nickerson's employment agreement provides for a two year severance period,
while the agreements with Messrs. Duncan and Fink provide for 18 month severance
periods. If we terminate an officer's employment without cause or the officer
resigns for good reason, we will pay the officer's base salary and bonus, if
any, for the applicable severance period and also unvested stock options which
are scheduled to vest during the severance period will vest immediately. Upon
termination following any change in control, defined to include any
recapitalization, merger or sale of substantially all of our assets, we will
also pay the officer's base salary and bonus, if any, for the applicable
severance period and all unvested stock options will vest immediately.
Each employment agreement contains a noncompetition covenant, which has a 24
month duration in the case of Mr. Nickerson and 18 month duration in the cases
of Mr. Duncan and Mr. Fink. The agreements also contain confidentiality,
nondisclosure and assignment of invention provisions.
1997 AND 1999 STOCK OPTION PLANS
N2H2's stock option plans include the 1997 Stock Option Plan, as amended, and
the 1999 Stock Option Plan. The Nonemployee Director Stock Option Plan is
described separately below. Our board of directors
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adopted our 1997 Plan on September 30, 1997, and our shareholders approved it on
October 21, 1997. The board adopted our 1999 Plan on March 19, 1999, and our
shareholders approved it on April 2, 1999. The plans provide for grants of
incentive stock options that qualify under Section 422 of the Internal Revenue
Code to employees, including officers, of N2H2 or any affiliate of N2H2, and
nonstatutory stock options to employees, including officers or directors of and
consultants to N2H2 or any affiliate of N2H2. The board of directors or a
committee appointed by the board administers the plans. References to the board
in this description of the plans include any such committee. Our board of
directors has the authority to determine which recipients and what types of
awards are to be granted, including the exercise price, number of shares subject
to the award and conditions of exercise.
The term of a stock option granted under the plans generally may not exceed 10
years. The board of directors determines the exercise price of options granted
under the plans. In the case of an incentive stock option, the exercise price
cannot be less than 100% of the fair market value of our common stock on the
date of grant. Options granted under the plans vest at the rate specified in the
option agreement. An optionee may not transfer options other than by will or the
laws of descent or distribution.
No incentive stock option may be granted to any person who, at the time of the
grant, owns or is deemed to own, stock that has more than 10% of the total
combined voting power of N2H2 or any affiliate of N2H2, unless the option
exercise price is at least 110% of the fair market value of the stock subject to
the option on the date of grant and the term of the option does not exceed five
years from the date of grant. In addition, $100,000 is the maximum amount
permitted for the aggregate fair market value, determined at the time of grant,
of the shares of our common stock covered by incentive stock options exercisable
for the first time by an optionee during any calendar year under the stock
option plans of N2H2 and its affiliates. The options or portions of options that
exceed this limit are treated as nonstatutory options.
Shares subject to stock awards that have lapsed or terminated, without having
been exercised in full, may again become available for the grant of awards under
the plans unless the plan under which the option was granted has been
terminated.
Options granted under the 1997 Plan vest over a three year schedule, with annual
vesting on the first, second and third anniversaries of employment. Options that
have been granted to date under the 1999 Plan vest on a similar basis but over a
four year period. The Plans provide for the vesting of options granted before
September 1998 to accelerate and become fully vested if a change of control of
N2H2 occurs. The form of Incentive Stock Option Agreement under the 1999 Plan
provides that if a change of control of N2H2 occurs, any options granted under
an Incentive Stock Option Agreement that are scheduled to vest within 15 months
after the date of the change of control will immediately vest, and any options
scheduled to vest beyond 15 months after the date of the change of control will
terminate.
At the inception of the 1997 Plan, the board based its initial fair market
valuation of the common stock at the time of grant of the initial options on the
third party transaction with The Segale Group dated July 31, 1996. In that
transaction, Mark Segale purchased 1,225,000 shares at $0.16 per share. Initial
grants under the 1997 Plan were valued at $0.18. Since then, the board has
considered the following factors, among others, in determining the fair market
value of the common stock at the time of grants under the 1997 Plan and 1999
Plan:
- growth of N2H2's sales and revenues,
- liquidity and
- solicited and unsolicited third party valuations of N2H2.
As of July 7, 1999, options to purchase 1,476,250 shares were outstanding and
9,501 shares were available for future grant under our 1997 Plan. As of the same
date, 1,329,625 shares were authorized, options to purchase 1,323,499 shares had
been granted and 6,126 shares were available for future grant under our 1999
Plan. Our 1997 Plan and our 1999 Plan will terminate on September 30, 2007, and
on March 19, 2009 respectively, unless terminated sooner by the board.
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<PAGE> 69
1999 NONEMPLOYEE DIRECTOR STOCK OPTION PLAN. The 1999 Nonemployee Director
Stock Option Plan was adopted by our board on May 10, 1999, and approved by our
shareholders on June 11, 1999. We have reserved 87,500 shares of common stock
for issuance under the 1999 Nonemployee Director Stock Option Plan. Under the
1999 Nonemployee Director Stock Option Plan, each of our nonemployee directors
is granted an option to purchase 3,750 shares of common stock upon becoming a
member of our board, and an option to purchase 3,750 shares of common stock
immediately following each of our annual shareholder meetings. The exercise
price of options to be granted under the 1999 Nonemployee Director Stock Option
Plan will equal the fair market value of our common stock on the date of grant.
Options granted under the 1999 Nonemployee Director Stock Option Plan will be
fully exercisable beginning six months after the date of grant for a 10 year
period from the date of grant. As of the date of this prospectus, no options
have been granted under the 1999 Nonemployee Director Stock Option Plan.
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<PAGE> 70
PRINCIPAL AND SELLING SHAREHOLDERS
The following table summarizes information regarding the beneficial ownership of
our outstanding common stock as of July 7, 1999 for:
- each of the selling shareholders,
- each person or group that we know owns more than 5% of our common stock,
- each of our directors,
- our chief executive officer,
- the officers whose compensation exceeded $100,000 and
- all of our directors and executive officers as a group.
Beneficial ownership is determined in accordance with rules of the Securities
and Exchange Commission and includes shares over which the indicated beneficial
owner exercises voting and/or investment power. Shares of common stock subject
to options currently exercisable or exercisable within 60 days are deemed
outstanding for computing the percentage ownership of the person holding the
options, but are not deemed outstanding for computing the percentage ownership
of any other person. Except as otherwise indicated, we believe the beneficial
owners of the common stock listed below, based on information furnished by them,
have sole voting and investment power with respect to the number of shares
listed opposite their names.
Unless otherwise indicated, the following officers, directors and shareholders
can be reached at our principal offices. The address for Mark A. Segale, Lisa M.
Atkins, Tina A. Covey, Nita S. Johnson, Ann J. Nichols and Donna A. Segale is
18000 Andover Park West, Suite 200, Tukwila, Washington 98188. The percentages
of ownership listed below are based on 15,647,607 shares of our common stock
outstanding prior to the offering and 20,097,607 shares outstanding after the
offering. Shares of common stock issuable for options outstanding and
exercisable within 60 days after the date of this prospectus are deemed to be
outstanding for purposes of computing the percentages of ownership for the
option holders but not for other listed shareholders.
<TABLE>
<CAPTION>
SHARES BENEFICIALLY SHARES BENEFICIALLY
OWNED PRIOR TO OFFERING OWNED AFTER OFFERING
SELLING SHAREHOLDERS, DIRECTORS, ----------------------- SHARES ----------------------
OFFICERS AND 5% SHAREHOLDERS NUMBER PERCENT OFFERED NUMBER PERCENT
-------------------------------- --------- ---------- ------- --------- ----------
<S> <C> <C> <C> <C> <C>
Peter H. Nickerson(1).................... 6,461,942 41.3% -- 6,461,942 32.2%
Hollis R. Hill(2)........................ 4,906,942 31.4 -- 4,906,942 24.4
Kevin E. Fink(3)......................... 723,332 4.6 -- 723,332 3.6
John F. Duncan(4)........................ 187,935 1.2 -- 187,935 *
Robert S. London
809 Presidio Avenue, Suite B,
Santa Barbara, CA 93101(5)............. 1,598,520 10.2 -- 1,598,520 8.0
Mark A. Segale(6)(7)..................... 1,786,316 11.4 28,445 1,757,871 8.7
Lisa M. Atkins(6)(8)..................... 459,117 2.9 7,310 451,807 2.2
Tina A. Covey(6)(9)...................... 459,117 2.9 7,310 451,807 2.2
Nita S. Johnson(6)(10)................... 226,571 1.4 3,610 222,961 1.1
Donna A. Segale(6)(11)................... 115,948 * 1,845 114,103 *
Ann J. Nichols(6)(12).................... 92,888 * 1,480 91,408 *
All current executive officers and
directors as a group (5 persons)....... 9,159,525 57.6% 50,000 9,131,080 45.0%
</TABLE>
- ---------------------------
* Less than one percent.
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<PAGE> 71
(1) Includes 374,062 shares of our common stock held by Mr. Nickerson,
4,532,880 shares of our common stock held jointly with his wife, Hollis
Hill, 1,400,000 shares of our common stock held by him as custodian under
the Uniform Transfers to Minors Act for the benefit of their children, and
155,000 shares for which he exercises sole voting power under an
irrevocable proxy granted by Jennifer Perenchio.
(2) Includes 4,532,880 shares of our common stock held by Ms. Hill jointly with
her husband, Mr. Nickerson, and 374,062 shares of our common stock held as
community property by her husband, Mr. Nickerson. Excludes 1,400,000 shares
of our common stock held by her husband as custodian under the Uniform
Transfers to Minors Act for the benefit of their children.
(3) Includes 700,000 shares of common stock held Mr. Fink and 23,332 options to
purchase common stock currently outstanding and exercisable held by his
wife, Jessica Lyman.
(4) Consists of 15,000 shares of common stock and options to purchase 172,935
shares of common stock held by Mr. Duncan and currently exercisable.
(5) Includes 1,457,610 shares of common stock and warrants to purchase 140,910
shares of common stock held by Mr. London that are currently exercisable.
(6) Mr. Segale, Lisa M. Atkins, Tina A. Covey, Nita S. Johnson, Ann J. Nichols
and Donna A. Segale, collectively partners of The Segale Group, are parties
to a Registration Rights Agreement among the same shareholders and us,
which provide that Mr. Segale has various powers related to the shares held
by the other Segale Group shareholders. The number of shares offered by
these shareholders is estimated based upon the midpoint of the price range
set forth on the cover of this prospectus.
(7) The number of shares held by Mr. Segale prior to the offering includes
1,735,166 shares of our common stock and a warrant to purchase 51,150
shares of our common stock which will be cancelled upon the sale of 28,445
shares of common stock under this offering.
(8) Includes 445,827 shares of common stock and warrants to purchase 13,290
shares of our common stock held by Ms. Atkins, which are currently
exercisable and which will be cancelled upon her sale of 7,310 shares under
this offering.
(9) Includes 445,827 shares of common stock and warrants to purchase 13,290
shares of our common stock held by Ms. Covey, which are currently
exercisable and which will be cancelled upon her sale of 7,310 shares under
this offering.
(10) Includes 219,940 shares of common stock and warrants to purchase 6,631
shares of our common stock held by Ms. Johnson, which are currently
exercisable and which will be cancelled upon her sale of 3,610 shares under
this offering.
(11) Includes 112,628 shares of common stock and warrants to purchase 3,320
shares of our common stock held by Ms. Segale, which are currently
exercisable and which will be cancelled upon her sale of 1,845 shares under
this offering.
(12) Includes 90,228 shares of common stock and warrants to purchase 2,660
shares of our common stock held by Ms. Nichols, which are currently
exercisable and which will be cancelled upon her sale of 1,480 shares under
this offering.
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<PAGE> 72
CERTAIN TRANSACTIONS
We believe that each of the transactions described below was carried out on
terms that were no less favorable to us than those that would have been obtained
from unaffiliated third parties. Any future transactions between us and any of
our directors, officers or principal shareholders will be on terms no less
favorable to us than could be obtained from unaffiliated third parties and will
be approved by a majority of the independent and disinterested members of the
board of directors.
COMMON STOCK ISSUANCES
Since October 1, 1997, we have issued and sold securities to the following
persons who are our executive officers and directors:
- Peter H. Nickerson and Hollis R. Hill: On January 28, 1999, Mr. Nickerson
and Ms. Hill purchased 937 shares of our common stock at a price per share of
$1.18, or an aggregate of $1,110. On December 31, 1998, and in conjunction
with our contemplated transition from an S corporation to a C corporation, we
redeemed 500,000 shares of common stock held by Mr. Nickerson and Ms. Hill at
a price per share of $1.18 or an aggregate of $592,000. Mr. Nickerson and Ms.
Hill in turn purchased 500,000 shares of common stock from us on December 31,
1998, at a price per share of $1.18 or an aggregate of $592,000. On December
31, 1998, we issued and sold 51,943 shares of common stock to Mr. Nickerson
and Ms. Hill, a marital community, at a price per share of $1.18, or an
aggregate of $61,500. Mr. Nickerson currently serves as President, Chief
Executive Officer and Chairman of the board of N2H2. Ms. Hill serves as a
director of ours. Mr. Nickerson and Ms. Hill are married.
- John F. Duncan: On May 15, 1999, Mr. Duncan exercised options to purchase
15,000 shares of common stock at a price per share of $0.18 for an aggregate
amount of $2,742. On March 17, 1999, Mr. Duncan exercised options to purchase
73,900 shares of common stock at a price per share of $0.18 for an aggregate
of $13,509. Mr. Duncan subsequently made a gift of these shares to his adult
children and sister. Mr. Duncan currently serves as our Vice
President -- Chief Financial Officer, Secretary and Treasurer.
- Mark A. Segale: In conjunction with this offering, Mr. Segale will sell
28,445 shares of common stock under a Registration Rights Agreement dated
effective as of December 31, 1998, among Mr. Segale, some of our other
shareholders and us. In connection with this sale, warrants to purchase
51,150 shares of common stock held by Mr. Segale will be cancelled. Effective
as of December 31, 1998, we issued to Mr. Segale, for the community of him
and Keri D. Segale, 212,818 shares of common stock together with warrants to
purchase 51,150 shares of common stock in connection with the conversion of a
$500,000 loan balance under a Loan and Stock Option Agreement dated July 31,
1996 into 1,632,500 shares of common stock.
THE SEGALE GROUP
On July 31, 1996, we entered into a Loan and Stock Option Agreement with The
Segale Group, a Washington general partnership, of which Mr. Segale, currently a
director and 5% shareholder of ours, was managing partner. That agreement
provided for maximum borrowings of $500,000 in $100,000 increments drawn at our
option. The outstanding principal bore interest at 12.0% per annum and was to be
payable on July 31, 1999. In connection with that loan, we issued warrant
equivalents to purchase 2.2% of our outstanding common stock for each $100,000
of outstanding debt. The warrant equivalents, in the aggregate, represented
11.0% of our outstanding common stock. The agreement also included an anti-
dilution provision that allowed The Segale Group to maintain an aggregate 25%
ownership interest in N2H2 including the 1,225,000 shares of common stock
already owned by them.
As of December 31, 1998, the outstanding loan balance under the Loan and Stock
Option Agreement was $500,000. Under a Loan Conversion Agreement dated April 8,
1999, and dated effective as of
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<PAGE> 73
December 31, 1998, we issued 1,632,500 shares of common stock and warrants to
purchase 93,000 shares of common stock at a price per share of $0.004 per share
to Mr. Segale, Lisa M. Atkins, Tina A. Covey, Nita S. Johnson, Ann J. Nichols,
Donna A. Segale and Samir J. Tuma, all partners in The Segale Group. These
warrants expire on the earlier of (a) December 31, 2003, or (b) an initial
public offering of our common stock where partners of The Segale Group are
allowed to sell shares of our common stock at an aggregate offering price of
$500,000. The warrants are exercisable at an adjusted price per share of $0.004.
We have included The Segale Group partners' offer to sell shares of common stock
at an aggregate offering price of $500,000 under this prospectus. Therefore,
these warrants will be cancelled upon conclusion of this offering.
Under a Registration Rights Agreement dated effective as of December 31, 1998,
The Segale Group partners have rights to require us to register their 3,154,845
shares of common stock and the 93,000 shares of common stock subject to warrants
to purchase common stock held by them.
Seattle Tractor Parts and Equipment, Inc., loaned $400,000 to us on April 11,
1997, represented by a promissory note secured by a pledge of shares of common
stock from Mr. Nickerson and Ms. Hill. Mr. Segale is the president of Seattle
Tractor Parts and Equipment, Inc. In connection with the April 8, 1999 Loan
Conversion Agreement, we repaid all outstanding principal and accrued interest
on that loan.
DEBT AND EQUITY FINANCINGS
In a series of related transactions under a Securities Purchase Agreement, as
amended, dated December 31, 1998, and January 26, 1999, we issued to a group of
18 investors:
- 1,687,113 shares of common stock at a price per share of $1.16, net of
commissions,
- warrants to purchase a total of 465,000 shares of our common stock at a
price per share of $3.14 and
- promissory notes in an aggregate amount of $2.0 million.
The investor group included Robert London, a holder of more than 5% of our
common stock. The note payable to Mr. London was in the amount of $606,060, plus
interest at 11.5% per annum. The warrants expire on December 30, 2003. The
warrants may be exercised either by paying cash or surrendering the warrants in
exchange for a number of shares equal to:
- the difference in value between the exercise price of the surrendered
warrants and the fair market value of our common stock as reported on an
organized stock exchange at the close of business the day before exercise,
- the market price multiplied by the number of shares represented by the
warrants and
- divided by the market price.
Under a Registration Rights Agreement dated effective as of December 31, 1998,
the investors under those agreements have rights to require us to register their
1,691,693 shares of common stock, including 4,850 shares issued upon the
exercise of warrants, and 460,420 shares of common stock subject to warrants to
purchase common stock held by them.
The Securities Purchase Agreement, as amended, provides that we will pay
Cruttenden Roth Bridge Fund, LLC, a commission and a private placement fee. To
date, we have paid $362,944 to Cruttenden Roth in commission and placement fees,
together with $30,000 in attorneys' fees associated with the transactions. Mr.
London is a managing director of Cruttenden Roth Inc.
On May 11, 1999, we completed a private equity financing in which we sold
2,705,648 shares of common stock to investors at a price per share of $3.70 for
an aggregate of $10,000,129. In connection with this financing, Mr. London's
$606,060 promissory note, plus accrued interest of $2,126, was satisfied and
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<PAGE> 74
exchanged for 164,552 shares of common stock. We also paid Cruttenden Roth Inc.
$200,000 in placement agent fees associated with closing of this private
financing.
EMPLOYMENT AGREEMENTS
We have entered into employment agreements with several of our key employees,
including Peter H. Nickerson, John F. Duncan and Kevin Fink. These agreements,
which include provisions requiring severance payments if a change of control
occurs, are described in "Management -- Employment Agreements."
DEFERRED EMPLOYEE COMPENSATION
In a letter agreement with Mr. Nickerson dated April 15, 1997, we agreed to pay
Mr. Nickerson $185,000 in employment compensation the payment of which had been
deferred. In December 1998, we paid Mr. Nickerson the full amount of that
obligation.
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<PAGE> 75
DESCRIPTION OF CAPITAL STOCK
Our restated articles of incorporation authorize us to issue, subject to
shareholder approval, up to 250,000,000 shares of common stock, no par value per
share and 50,000,000 shares of preferred stock, no par value per share. The
following summary of certain provisions of the common stock and preferred stock
is not complete and may not contain all the information you should consider
before investing in the common stock. You should read carefully our restated
articles of incorporation, which are included as an exhibit to the registration
statement, of which this prospectus is a part.
COMMON STOCK
As of July 7, 1999 there were 15,647,607 shares of common stock outstanding held
of record by 107 shareholders. Following this offering, there will be 20,097,607
shares of common stock outstanding, provided that there has been no exercise of
the Underwriters' over-allotment option and no exercise of outstanding options.
The holders of common stock are entitled to one vote per share on all matters to
be voted on by the shareholders. Subject to preferences of any outstanding
shares of preferred stock, the holders of common stock are entitled to receive
ratably any dividends the board of directors declares out of funds legally
available for the payment of dividends. We have not paid any cash dividends
since our inception. See "Dividend Policy" for a more detailed statement of our
dividend history. If N2H2 is liquidated, dissolved or wound up, the holders of
common stock are entitled to share pro rata all assets remaining after payment
of liabilities and liquidation preferences of any outstanding shares of
preferred stock. Holders of common stock have no preemptive rights or rights to
convert their common stock into any other securities. There are no redemption or
sinking fund provisions applicable to the common stock. All outstanding shares
of common stock are fully paid and nonassessable and the shares of common stock
to be issued following this offering will be fully paid and nonassessable.
PREFERRED STOCK
The board of directors, without shareholder approval, can issue preferred stock
with voting, conversion or other rights that could adversely affect the voting
power and other rights of the holders of common stock. Preferred stock could
thus be issued quickly with terms that could delay or prevent a change in
control of N2H2 or make removal of management more difficult. Additionally, the
issuance of preferred stock may decrease the market price of the common stock
and may adversely affect the voting and other rights of the holders of common
stock. We currently have no plans to issue any preferred stock.
REGISTRATION RIGHTS
In connection with several transactions, we have entered into registration
rights agreements with several shareholders, including Robert London and Mark
Segale, covering an aggregate of 10,805,268 shares of our common stock together
with 553,420 warrants to purchase our common stock, 93,000 of which will be
terminated upon completion of this offering. Under the registration rights
agreements, these shareholders are entitled to the registration of their shares
under the Securities Act in specified contexts. If we propose to register any of
our securities under the Securities Act, either for our own account or for the
account of other security holders, the shareholders holding registration rights
are entitled to notice of such registration and have rights to include their
shares of common stock in such registration at our expense. Additionally, these
shareholders may require us to file additional registration statements on Form
S-3 at our expense. All of these registration rights are subject to specified
conditions and limitations, among them the right of the underwriters of an
offering to limit the number of shares included in such registration. However,
in the absence of the underwriters giving approval for the inclusion of shares
in this offering, the registration rights agreements require the holders to
execute 180 day lock-up agreements. Under the lock up agreements, the
shareholders agree not to sell, enter agreements to sell or hypothecate the
shares covered by registration rights agreements for a period of 180 days
following this offering.
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<PAGE> 76
WARRANTS
As of December 31, 1998, we issued warrants to purchase 93,000 shares of common
stock at a per share price of $0.004 to Mark A. Segale, Lisa M. Atkins, Tina A.
Covey, Nita S. Johnson, Ann J. Nichols, Donna A. Segale and Samir J. Tuma. These
warrants expire on the earlier of (a) December 31, 2003, or (b) an initial
public offering of our common stock where the partners in The Segale Group are
allowed to sell shares of our common stock at an aggregate offering price of
$500,000, as selling shareholders. In satisfaction of this obligation, we have
included the offer by the partners of The Segale Group to sell 50,000 shares of
common stock under this prospectus. Therefore, these warrants will be cancelled
upon conclusion of this offering.
In connection with a series of transactions dated December 31, 1998 and January
26, 1999, we issued warrants to purchase 465,000 shares of our common stock at a
per share price of $3.14 to a group of 17 investors, including Robert London, a
holder of more than 5% of our common stock. Of these warrants, 460,420 remained
outstanding as of July 7, 1999. The warrants may be exercised either by paying
cash or surrendering the warrants in exchange for a number of shares equal to:
- the difference in value between the exercise price of the surrendered
warrants and the fair market value of our common stock as reported on an
organized stock exchange at the close of business the day before exercise,
- the market price multiplied by the number of shares represented by the
warrants and
- divided by the market price.
ANTI-TAKEOVER EFFECTS OF PROVISIONS OF OUR RESTATED ARTICLES, AMENDED BYLAWS AND
WASHINGTON LAW
As noted above, our board of directors, without shareholder approval, has the
authority under our restated articles of incorporation to issue preferred stock
with rights superior to the rights of the holders of common stock. As a result,
preferred stock could be issued quickly and easily, could adversely affect the
rights of holders of common stock and could be issued with terms calculated to
delay or prevent a change in control of N2H2 or make removal of management more
difficult.
Washington law imposes restrictions on transactions between a corporation and
its significant shareholders under circumstances defined in Chapter 23B.19 of
the Washington Business Corporations Act. Specifically, a "target corporation"
is prohibited, with exceptions defined in the statute, from engaging in
specified significant business transactions with an acquiring person. An
acquiring person is defined as a person or group of persons that beneficially
owns 10% or more of the voting securities of the target corporation. The
restriction applies for a period of five years after such acquisition, unless
the transaction or acquisition of shares is approved by a majority of the
members of the target corporation's board of directors prior to the time of
acquisition. Prohibited transactions include, among other things:
- a merger or consolidation with, disposition of assets to or issuance or
redemption of stock to or from, the acquiring person,
- termination of 5% or more of the employees of the target corporation as a
result of the acquiring person's acquisition of 10% or more of the shares or
- allowing the acquiring person to receive any disproportionate benefit as a
shareholder.
After the five-year period, a "significant business transaction" may occur, as
long as it complies with the "fair price" provisions of the statute. A
corporation may not "opt out" of this statute. This provision may have the
effect of delaying, deterring or preventing a change in control of N2H2.
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Election and removal of directors
Effective with the first annual meeting of shareholders following this offering,
our restated articles of incorporation provide for the division of our board of
directors into three classes, as nearly as equal in number as possible, with the
directors in each class serving staggered three-year terms and one class being
elected each year by our shareholders. Directors may be removed, prior to the
expiration of their terms, only for cause. Because this system of electing and
removing directors generally makes it more difficult for shareholders to replace
a majority of the board of directors, it may tend to discourage a third party
from making a tender offer or otherwise attempting to gain control of N2H2 and
may maintain the incumbency of the board of directors.
Shareholder meetings
Under our restated articles of incorporation and amended bylaws, our
shareholders may call a special meeting only upon the request of holders of at
least 25% of the outstanding shares. Additionally, the board of directors and
the president may call special meetings of shareholders. Upon our becoming a
public company, a special meeting of shareholders may be called only by the
president or a majority of the board of directors.
Requirements for advance notification of shareholder nominations and proposals
Our amended bylaws establish advance notice procedures for shareholder proposals
and the nomination of candidates for election as directors, other than
nominations made by or at the direction of the board of directors or a board
committee.
Transfer Agent and Registrar
ChaseMellon Shareholder Services, L.L.C. is the transfer agent and registrar for
our common stock. Its telephone number is (206) 674-3030.
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<PAGE> 78
SHARES ELIGIBLE FOR FUTURE SALE
Immediately prior to this offering, there was no public market for our common
stock. Future sales of substantial amounts of common stock in the public market
could adversely affect the market price of the common stock.
Upon completion of this offering, we will have 20,097,607 shares of common stock
outstanding, assuming the issuance of 4,450,000 shares of common stock offered
hereby, conversion of all shares of preferred stock and no exercise of options
or warrants after July 7, 1999. Of these shares, the 4,500,000 shares sold in
this offering will be freely tradable without restriction or further
registration under the Securities Act; provided, however, that if shares are
purchased by "affiliates," as that term is defined in Rule 144 under the
Securities Act, their sales of shares would be subject to limitations and
restrictions that are described below.
The remaining 15,597,607 shares of common stock held by existing shareholders as
of July 7, 1999 were issued and sold by us in reliance on exemptions from the
registration requirements of the Securities Act. Of these shares, 15,460,965
shares will be subject to lock-up agreements described below on the effective
date of the offering. Upon expiration of the lock-up agreements 180 days after
the effective date of this prospectus, 15,460,965 shares will become eligible
for sale, subject in most cases to the limitations of Rule 144. In addition,
holders of stock options and warrants could exercise their options and warrants
and sell the shares issued upon exercise as described below.
<TABLE>
<CAPTION>
DAYS AFTER DATE OF SHARES ELIGIBLE
THIS PROSPECTUS FOR SALE COMMENT
------------------ --------------- ---------------------------------------
<S> <C> <C>
Upon effectiveness..................... 4,500,000 Shares sold in the offering
90 days................................ 186,642 Shares saleable under Rule 144 that are
not subject to the lock-up agreements
180 days............................... 15,460,965 Lock-up released: shares saleable under
Rules 144 and 701
</TABLE>
As of July 7, 1999, there were a total of 553,420 shares of common stock that
could be issued upon exercise of outstanding warrants. All of these shares are
subject to lock-up agreements. As of July 7, 1999, there were a total of
2,799,749 shares of common stock subject to outstanding options under our stock
plans, 728,272 shares of which were vested. Some of these shares are also
subject to lock-up agreements. Promptly upon the completion of this offering, we
intend to file registration statements on Form S-8 under the Securities Act to
register all of the shares of common stock issued or reserved for future
issuance under our stock plans. After the effective dates of the registration
statements on Form S-8, shares purchased upon exercise of options granted under
our 1997 Stock Option Plan and 1999 Stock Option Plan and 1999 Nonemployee
Director Stock Option Plan generally would be available for resale in the public
market.
Our officers, directors and the majority of our shareholders have agreed not to
sell or otherwise dispose of any of their shares for a period of 180 days after
the date of this prospectus. CIBC World Markets Corp., however, may in its sole
discretion, at any time and in most cases without notice, release all or any
portion of the shares subject to lock-up agreements.
RULE 144
In general, under Rule 144 as currently in effect, beginning 90 days after the
date of this prospectus, a person who has beneficially owned shares of our
common stock for at least one year would be entitled to sell, within any three
month period, a number of shares that does not exceed the greater of:
- 1% of the number of shares of common stock then outstanding, which will equal
approximately 200,976 shares immediately after the effective date of this
offering or
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<PAGE> 79
- the average weekly trading volume of the common stock on the Nasdaq National
Market during the four calendar weeks preceding the filing of a notice on
Form 144 with respect to this sale.
Sales under Rule 144 are also subject to other requirements regarding the manner
of sale, notice filing and the availability of current public information about
us.
RULE 701
In general, under Rule 701, any of our employees, directors, officers,
consultants or advisors who purchase shares from us in connection with a
compensatory stock or option plan or other written agreement before the
effective date of the offering are entitled to resell these shares 90 days after
the effective date of this prospectus in reliance on Rule 144, without having to
comply with certain restrictions, including the holding period, contained in
Rule 144.
The Securities and Exchange Commission has indicated that Rule 701 will apply to
typical stock options granted by an issuer before it becomes subject to the
reporting requirements of the Exchange Act, along with the shares acquired upon
exercise of these options, including exercises after the date of the prospectus.
Securities issued in reliance on Rule 701 are restricted securities and, subject
to the contractual restrictions described above may be sold, beginning 90 days
after the date of this prospectus, by persons other than affiliates subject only
to the manner of sale provisions of Rule 144 and by affiliates under Rule 144
without compliance with its one year minimum holding period requirement.
In addition, following this offering, the holders of 10,805,268 shares of common
stock and of warrants exercisable for 460,420 shares of common stock will, under
circumstances defined in a Registration Rights Agreement dated effective as of
December 31, 1998, have rights to require us to register their shares for future
sale.
LOCK-UP AGREEMENTS
All executive officers and directors and the majority of the holders of common
stock or securities convertible into common stock and options and warrants to
purchase common stock have signed lock-up agreements stating that they will not
offer, sell, contract to sell, pledge, grant any option to sell, or otherwise
dispose of, directly or indirectly, any shares of common stock, securities
convertible or exchangeable for common stock, warrants or other rights to
purchase common stock for a period of 180 days after the date of this
prospectus, without the prior written consent of CIBC World Markets Corp.
68
<PAGE> 80
UNDERWRITING
N2H2, Inc. and the selling shareholders have entered into an underwriting
agreement with the underwriters named below. CIBC World Markets Corp. and U.S.
Bancorp Piper Jaffray Inc. are acting as representatives of the underwriters.
The underwriting agreement provides for the purchase of a specific number of
shares of common stock by each of the underwriters. The underwriters'
obligations are several, which means that each underwriter is required to
purchase a specified number of shares, but is not responsible for the commitment
of any other underwriter to purchase shares. Subject to the terms and conditions
of the underwriting agreement, each underwriter has severally agreed to purchase
from N2H2 and the selling shareholders the following numbers of shares of common
stock:
<TABLE>
<CAPTION>
UNDERWRITER NUMBER OF SHARES
----------- ----------------
<S> <C>
CIBC World Markets Corp.....................................
U.S. Bancorp Piper Jaffray Inc. ............................
----------------
Total....................................................... 4,500,000
================
</TABLE>
This is a firm commitment underwriting. This means that the underwriters have
agreed to purchase all of the shares offered by this prospectus, if any are
purchased, other than those covered by the over-allotment option described
below.
The representatives have advised us and the selling shareholders that the
underwriters propose to offer the shares directly to the public at the public
offering price that appears on the cover page of this prospectus. In addition,
the representatives may offer some of the shares to some securities dealers at
this price less a concession of $ per share. The underwriters may also
allow, and these dealers may reallow, a concession not in excess of $ per
share to other dealers. After the shares are released for sale to the public,
the representatives may change the offering price and other selling terms at
various times.
We have granted the underwriters an over-allotment option. This option, which is
exercisable for up to 30 days after the date of this prospectus, permits the
underwriters to purchase a maximum of 675,000 additional shares from us to cover
over-allotments. If the underwriters exercise all or part of this option, they
will purchase shares covered by the option at the initial public offering price
that appears on the cover page of this prospectus, less the underwriting
discount. If this option is exercised in full, the total price to public will be
$ and the total proceeds to us will be $ and the total
proceeds to the selling shareholders will be $ . The underwriters have
severally agreed that, to the extent the over-allotment option is exercised,
they will each purchase a number of additional shares proportionate to the
underwriter's initial amount reflected in the table above.
The following table provides information regarding the amount of the discount to
be paid to the underwriters by N2H2 and the selling shareholders.
<TABLE>
<CAPTION>
TOTAL WITH FULL
EXERCISE OF
TOTAL WITHOUT EXERCISE OF OVER-ALLOTMENT
PER SHARE OVER-ALLOTMENT OPTION OPTION
--------- ------------------------- ---------------
<S> <C> <C> <C>
N2H2, Inc..................................... $ $ $
Selling shareholders.......................... $ $ $
Total.................................... $ $ $
</TABLE>
69
<PAGE> 81
Together with the selling shareholders, we have agreed to indemnify the
underwriters against specified liabilities, including liabilities under the
Securities Act.
N2H2, its officers and directors and the majority of its shareholders have
agreed to a 180 day "lock up" with respect to 15,460,965 shares of common stock
and other N2H2 securities that they beneficially own, including options to
purchase shares of common stock. This means that, for a period of 180 days
following the date of this prospectus, N2H2 and other such persons may not
offer, sell, pledge or otherwise dispose of our securities without the prior
written consent of CIBC World Markets Corp.
The representatives have informed us that they do not expect discretionary sales
by the underwriters to exceed five percent of the shares offered by this
prospectus.
There is no established trading market for shares of our common stock. The
offering price for the shares of our common stock has been determined by us and
the underwriters, based on the following factors:
- negotiations among us and the underwriters,
- prevailing market and economic conditions,
- our financial information,
- our history and the prospects,
- N2H2 and the industry in which we compete,
- an assessment of our management, its past and present operations, the
prospects for and timing of, our future revenues and
- the present stage of our development and the above factors in relation to the
market values and various valuation measures of other companies engaged in
activities similar to ours.
The initial public offering price appearing on the cover page of this prospectus
should not, however, be considered an indication of the actual value of our
common stock. Such price is subject to change as a result of market conditions
and other factors. There can be no assurance that an active trading market will
develop for our common stock or that our common stock will trade in the public
market subsequent to this offering at or above its initial offering price.
The underwriters may engage in the following activities in accordance with the
rules of the Securities and Exchange Commission:
- Stabilizing transactions: the underwriters may make bids or purchases for the
purpose of pegging, fixing or maintaining the price of the shares, so long as
stabilizing bids do not exceed a specified maximum.
- Over-allotments and syndicate covering transactions: the underwriters may
create a short position in the shares by selling more shares than appear on
the cover page of this prospectus. If a short position is created in
connection with this offering, the underwriters may engage in syndicate
covering transactions by purchasing shares in the open market. The
underwriters may also elect to reduce any short position by exercising all or
part of the over-allotment option.
- Penalty bids: If the underwriters purchase shares in the open market in a
stabilizing transaction or syndicate covering transaction, they may reclaim a
selling concession from members of the underwriters syndicate who sold shares
as part of this offering.
Stabilization and syndicate covering transactions may cause the price of the
shares to be higher than it would be in the absence of such transactions. The
imposition of a penalty bid might also have an effect on the price of the shares
if it discourages resales of the shares. Neither we nor the underwriters make
any representation or prediction as to the effect that the transactions
described above may have on the price of
70
<PAGE> 82
the shares. These transactions may occur on the Nasdaq National Market or
otherwise. If such transactions are commenced, they may be discontinued without
notice at any time.
LEGAL MATTERS
The validity of the common stock offered hereby will be passed upon for us by
Lane Powell Spears Lubersky LLP, Seattle, Washington. Members of that firm
beneficially owned 50,887 shares of our common stock as of June 21, 1999.
Certain legal matters will be passed upon for the underwriters by Cooley Godward
LLP, Kirkland, Washington.
EXPERTS
The financial statements of N2H2 as of September 30, 1997 and 1998 and for each
of the three years in the period ended September 30, 1998, included in this
prospectus have been so included in reliance on the report of
PricewaterhouseCoopers LLP, independent accountants, given on the authority of
said firm as experts in auditing and accounting.
WHERE YOU CAN FIND MORE INFORMATION
We have filed with the Commission a registration statement on Form S-1. This
prospectus, which is part of the registration statement, does not contain all
the information included in the registration statement or its exhibits and
schedules. You should refer to the registration statement and its exhibits and
schedules. References made in this prospectus to any contract or other document
of ours are not necessarily complete and you should refer to the exhibits
attached to the registration statement for copies of the actual contract or
document. You may read and copy any document we file with the Commission at its
public reference rooms located at:
- Room 1024, Judiciary Plaza, 450 Fifth Street, N.W., Washington, D.C. 20549,
- Seven World Trade Center, Suite 1300, New York, New York 10048 or
- Citicorp Center, 500 West Madison Street, Suite 1400, Chicago, Illinois
60661.
The Commission maintains a Website at http://www.sec.gov that contains reports,
proxy and information statements and other information regarding registrants,
such as us, that file electronically with the Commission.
In addition, this prospectus includes market data relating to us and the school,
home and corporate internet markets. Some of this data was obtained from
industry publications and reports, such as reports by International Data
Corporation and The Annenberg Public Policy Center. These reports assume certain
events, trends and activities will occur and they project information on those
assumptions. We have not independently verified this data. Also, we have not
sought the consent of these organizations to refer to their reports in this
prospectus.
71
<PAGE> 83
N2H2, INC.
INDEX TO FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Report of Independent Accountants........................... F-2
Balance Sheets as of September 30, 1997 and 1998; March 31,
1999 (Unaudited).......................................... F-3
Statements of Operations for the Fiscal Years Ended
September 30, 1996, 1997 and 1998
and the Six Months Ended March 31, 1998 and 1999
(Unaudited)............................................... F-4
Statements of Changes in Shareholders' Deficit for the
Fiscal Years Ended September 30, 1996, 1997 and 1998 and
the Six Months Ended March 31, 1999 (Unaudited)........... F-5
Statements of Cash Flows for the Fiscal Years Ended
September 30, 1996, 1997 and
1998 and the Six Months Ended March 31, 1998 and 1999
(Unaudited)............................................... F-6
Notes to Financial Statements............................... F-7
</TABLE>
F-1
<PAGE> 84
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors
and Shareholders of
N2H2, Inc.
In our opinion, the financial statements listed in the accompanying index on
page F-1 present fairly, in all material respects, the financial position of
N2H2, Inc. at September 30, 1997 and 1998, and the results of its operations and
its cash flows for each of the three years in the period ended September 30,
1998, in conformity with generally accepted accounting principles. These
financial statements are the responsibility of the Company's management; our
responsibility is to express an opinion on these financial statements based on
our audits. We conducted our audits of these statements in accordance with
generally accepted auditing standards which require that we plan and perform the
audit to obtain reasonable assurance about whether the financial statements are
free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements,
assessing the accounting principles used and significant estimates made by
management, and evaluating the overall financial statement presentation. We
believe that our audits provide a reasonable basis for the opinion expressed
above.
PricewaterhouseCoopers LLP
Seattle, Washington
March 17, 1999, except as to the third
through sixth paragraphs of Note 12,
which are as of May 11, 1999 and
the seventh paragraph of Note 12
which is as of May 14, 1999
F-2
<PAGE> 85
N2H2, INC.
BALANCE SHEETS
<TABLE>
<CAPTION>
SEPTEMBER 30, MARCH 31,
------------------ 1999
1997 1998 (UNAUDITED)
------- ------- -----------
(IN THOUSANDS, EXCEPT SHARE
AMOUNTS)
<S> <C> <C> <C>
ASSETS
Current assets
Cash...................................................... $ 71 $ 121 $ 1,384
Accounts receivable (net of $0, $8 and $38 allowance in
1997, 1998 and 1999, respectively)..................... 259 321 735
Prepaid expenses and other assets......................... 37 3
------- ------- -------
Total current assets.............................. 330 479 2,122
Property and equipment, net................................. 453 1,271 2,045
Other assets................................................ 1 98 118
------- ------- -------
Total assets...................................... $ 784 $ 1,848 $ 4,285
======= ======= =======
LIABILITIES AND SHAREHOLDERS' DEFICIT
Current liabilities
Accounts payable.......................................... $ 79 $ 451 $ 652
Royalties payable......................................... 150 125
Accrued liabilities....................................... 97 461 621
Deferred revenue.......................................... 404 1,237 1,155
Current portion of long-term debt and notes payable....... 509 30 1,946
Current portion of capital lease obligations.............. 70 384 674
------- ------- -------
Total current liabilities......................... 1,159 2,713 5,173
Deferred revenue............................................ 97 173
Capital lease obligations................................... 132 524 688
Long-term debt and notes payable............................ 694 1,418 87
------- ------- -------
Total liabilities................................. 1,985 4,752 6,121
------- ------- -------
Commitments and contingencies (Notes 9 and 11)
Shareholders' deficit
Preferred stock, no par value; 10,000,000 shares
authorized, no shares issued and outstanding
Common stock, no par value; 20,000,000 shares authorized;
8,686,411, 9,060,473 and 12,656,933 issued and
outstanding in 1997, 1998 and 1999..................... 546 1,440 5,181
Deferred stock option compensation expense................ (658)
Accumulated deficit....................................... (1,747) (4,344) (6,359)
------- ------- -------
Total shareholders' deficit....................... (1,201) (2,904) (1,836)
------- ------- -------
Total liabilities and shareholders' deficit....... $ 784 $ 1,848 $ 4,285
======= ======= =======
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-3
<PAGE> 86
N2H2, INC.
STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
SIX MONTHS ENDED
YEARS ENDED SEPTEMBER 30, MARCH 31,
------------------------------------ -----------------------
1996 1997 1998 1998 1999
---------- ---------- ---------- ---------- ----------
(UNAUDITED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
<S> <C> <C> <C> <C> <C>
Revenues......................... $ 108 $ 1,118 $ 3,078 $ 1,298 $ 2,605
---------- ---------- ---------- ---------- ----------
Cost of revenues................. 78 302 1,153 453 1,254
---------- ---------- ---------- ---------- ----------
Gross profit..................... 30 816 1,925 845 1,351
---------- ---------- ---------- ---------- ----------
Operating expenses:
Sales and marketing............ 263 605 1,752 679 1,535
Research and development....... 91 371 614 252 394
General and administrative..... 493 602 1,869 483 1,190
---------- ---------- ---------- ---------- ----------
Total operating expenses.... 847 1,578 4,235 1,414 3,119
---------- ---------- ---------- ---------- ----------
Operating loss................... (817) (762) (2,310) (569) (1,768)
Interest income (expense), net... (10) (119) (287) (110) (247)
---------- ---------- ---------- ---------- ----------
Net loss......................... $ (827) $ (881) $ (2,597) $ (679) $ (2,015)
========== ========== ========== ========== ==========
Basic and diluted net loss per
common share................... $ (.11) $ (.10) $ (.30) $ (.08) $ (.19)
========== ========== ========== ========== ==========
Basic and diluted weighted
average shares outstanding..... 7,316,858 8,389,878 8,687,435 8,686,411 10,758,005
========== ========== ========== ========== ==========
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-4
<PAGE> 87
N2H2, INC.
STATEMENTS OF CHANGES IN SHAREHOLDERS' DEFICIT
<TABLE>
<CAPTION>
DEFERRED
COMMON STOCK STOCK OPTION
------------------- COMPENSATION ACCUMULATED
SHARES AMOUNT EXPENSE DEFICIT TOTAL
---------- ------ ------------ ----------- -------
(IN THOUSANDS, EXCEPT SHARE AMOUNTS)
<S> <C> <C> <C> <C> <C>
Balance at September 30, 1995........... 7,000,000 $ 32 $ -- $ (39) $ (7)
Issuance of common stock................ 1,389,063 275 275
Issuance of warrants.................... 41 41
Compensation expense recognized on
issuance of common stock.............. 166 166
Net loss................................ (827) (827)
---------- ------ ----- ------- -------
Balance at September 30, 1996........... 8,389,063 514 -- (866) (352)
Issuance of common stock................ 297,348 --
Issuance of warrants.................... 32 32
Net loss................................ (881) (881)
---------- ------ ----- ------- -------
Balance at September 30, 1997........... 8,688,411 546 -- (1,747) (1,201)
Exercise of stock options............... 374,062 75 75
Compensation expense recognized on
issuance of stock, stock options and
warrants.............................. 819 819
Net loss................................ (2,597) (2,597)
---------- ------ ----- ------- -------
Balance at September 30, 1998........... 9,060,473 1,440 -- (4,344) (2,904)
Issuance of common stock, net of
issuance costs of $243 (unaudited).... 1,738,053 1,957 1,957
Issuance of warrants (unaudited)........ 77 77
Conversion of notes payable into common
stock (unaudited)..................... 1,736,175 724 724
Exercise of stock options (unaudited)... 122,232 19 19
Compensation expense recognized on
issuance of common stock
(unaudited)........................... 185 185
Deferred compensation expense relating
to issuance of stock options
(unaudited)........................... 779 (779) --
Amortization of deferred stock option
compensation expense (unaudited)...... 121 121
Net loss (unaudited).................... (2,015) (2,015)
---------- ------ ----- ------- -------
Balance at March 31, 1999 (unaudited)... 12,656,933 $5,181 $(658) $(6,359) $(1,836)
========== ====== ===== ======= =======
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-5
<PAGE> 88
N2H2, INC.
STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
SIX MONTHS ENDED
YEARS ENDED SEPTEMBER 30, MARCH 31,
------------------------- ----------------
1996 1997 1998 1998 1999
----- ----- ------- ----- -------
(IN THOUSANDS) (UNAUDITED)
<S> <C> <C> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES
Net loss...................................... $(827) $(881) $(2,597) $(679) $(2,015)
Adjustments to reconcile net loss to net
cash (used by) provided by operating
activities
Depreciation and amortization............ 43 147 346 110 352
Amortization of deferred stock
compensation expense................... 121
Compensation expense on stock, stock
options and warrants................... 166 819 185
Notes payable issued for services........ 208 65 98 79
Change in certain assets and liabilities
Accounts receivable.................... (79) (152) (62) 123 (414)
Prepaid expenses and other assets...... (1) (134) (37) 14
Accounts payable....................... 51 29 372 59 201
Royalties payable...................... 150 (25)
Accrued liabilities.................... 31 66 364 187 160
Deferred revenue....................... 104 299 930 152 (6)
----- ----- ------- ----- -------
Net cash (used by) provided by
operating activities.............. (304) (427) 286 (6) (1,427)
----- ----- ------- ----- -------
CASH FLOWS FROM INVESTING ACTIVITIES
Additions to property and equipment......... (121) (230) (383) (101) (416)
----- ----- ------- ----- -------
CASH FLOWS FROM FINANCING ACTIVITIES
Issuance of common stock.................... 275 1,957
Exercise of stock options................... 19
Payments under capital lease obligations.... (15) (31) (51) (26) (201)
Borrowings under notes payable.............. 285 631 210 153 2,000
Repayments of notes payable................. (12) (4) (669)
----- ----- ------- ----- -------
Net cash provided by financing
activities........................ 545 600 147 123 3,106
----- ----- ------- ----- -------
Net increase (decrease) in cash............... 120 (57) 50 16 1,263
Cash, beginning of period..................... 8 128 71 71 121
----- ----- ------- ----- -------
Cash, end of period........................... $ 128 $ 71 $ 121 $ 87 $ 1,384
===== ===== ======= ===== =======
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-6
<PAGE> 89
N2H2, INC.
NOTES TO FINANCIAL STATEMENTS
SEPTEMBER 30, 1996, 1997 AND 1998
AND MARCH 31, 1998 AND 1999 (UNAUDITED)
1. DESCRIPTION OF BUSINESS
N2H2, Inc. (the Company) was incorporated on June 13, 1995 as an S Corporation
in the State of Washington. The Company develops and provides internet filtering
services which screen for undesired content as specified by the end user. The
Company contracts its technology primarily to internet service providers, school
districts, libraries and local and state government agencies.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
REVENUE RECOGNITION
Subscription and installation revenues are recognized when earned. Subscription
revenues are recognized over the life of the subscription contract and
installation revenues are recognized when the server is installed by the end
user, and when the criteria for revenue recognition under Statement of Position
No. 97-2, Software Revenue Recognition, are satisfied. The criteria include, but
are not limited to, the existence of vendor-specific objective evidence,
delivery of the service to a customer, the Company's lack of significant
obligations to the customer and a determination that collectibility of the
amount due is probable. Subscription payments received in advance of revenue
recognition are recorded as deferred revenue. Advertising revenues are recorded
on a per impression basis, net of commissions, over the term of the advertising
contract.
TRANSFER OF FINANCIAL INSTRUMENTS
The Company factors certain customer receivables with full recourse to a bank.
The transfer of accounts receivable is recorded by the Company as a sales
transaction under the provisions of Statement of Financial Accounting Standards
(SFAS) No. 125, Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities. The receivables are sold at a discount which is
recorded upon sale, and monthly finance charges are incurred based upon average
monthly balances outstanding with the factor. These monthly fees are recorded in
the period incurred. Customer accounts repurchased from the factor are included
in accounts receivable. In fiscal 1999, the Company terminated its factoring
agreement with the bank.
CONCENTRATION OF CREDIT RISK
Financial instruments that potentially subject the Company to concentration of
credit risk include primarily cash and cash equivalents and accounts receivable.
The Company places its cash deposits and certain short-term investments in bank
deposits and money market funds with high credit quality financial institutions.
Domestic accounts receivable consists of account balances due from customers
evenly dispersed across the United States with industry concentrations in public
institutions such as federal and local governments and school districts.
International accounts receivable represent 0% and 3% of total accounts
receivable at September 30, 1997 and 1998, respectively, and are denominated
primarily in United States dollars. The Company performs ongoing credit
evaluations of its customer's financial condition and generally requires no
collateral from its customers.
No customer accounted for 10% or more of the Company's revenues in any year.
F-7
<PAGE> 90
N2H2, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1996, 1997 AND 1998
AND MARCH 31, 1998 AND 1999 (UNAUDITED)
FAIR VALUE DISCLOSURES
Recorded amounts of cash and cash equivalents, receivables, prepaid expenses and
other current assets, capital lease obligations, accounts payable and other
amounts included in current liabilities meeting the definition of financial
instruments approximate fair value. The carrying value of long term debt is
based on interest rates currently available to the Company.
CASH AND CASH EQUIVALENTS
Cash and cash equivalents represent funds on deposit with banks or invested in a
variety of highly liquid short-term instruments with original maturities of less
than three months.
PROPERTY AND EQUIPMENT
Property and equipment is recorded at cost for purchased assets. Depreciation
and amortization are recognized using the straight-line method over the
estimated useful lives of such assets. The useful lives are estimated at three
years. Leasehold improvements are amortized over the lesser of the lease term or
estimated useful life.
The cost of normal maintenance and repairs are charged to expense as incurred
and expenditures for major improvements are capitalized, at cost. Gains or
losses on the disposition of assets in the normal course of business are
reflected in the results of operations at the time of disposal.
IMPAIRMENT OF LONG-LIVED ASSETS
The Company evaluates its long-lived assets for financial impairment and
continues to evaluate them as events or changes in circumstances indicate that
the carrying amount of such assets may not be fully recoverable. The Company
evaluates the recoverability of long-lived assets by measuring the carrying
amount of the assets against the estimated undiscounted future cash flows
associated with these assets. At the time such evaluations indicate that the
future undiscounted cash flows of certain long-lived assets are not sufficient
to recover the carrying value of such assets, the assets are adjusted to their
fair values.
ROYALTIES PAYABLE
Royalties payable represent amounts payable to an independent provider of
internet search content under a service agreement. Amortization is based on the
greater of amounts determined by the contractual royalty rates or amounts
computed on a straight-line basis over the terms of the agreement.
RESEARCH AND DEVELOPMENT COSTS
Research and development expenses consist principally of payroll and related
expenses for design and development of the Company's technologies. Research and
development costs related to these activities are expensed until technological
feasibility has been achieved. There were no capitalized software development
costs as of September 30, 1997 and 1998.
F-8
<PAGE> 91
N2H2, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1996, 1997 AND 1998
AND MARCH 31, 1998 AND 1999 (UNAUDITED)
FEDERAL INCOME TAXES
The shareholders of the Company have elected, under Subchapter S of the Internal
Revenue Code, to be taxed on the earnings of the Company on the shareholders'
personal income tax returns. Therefore, no provision for income taxes has been
provided for by the Company.
ADVERTISING EXPENSES
All costs related to marketing and advertising the Company's products are
expensed in the periods incurred. Advertising expenses were $37,000, $80,000,
and $120,000 for 1996, 1997 and 1998.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.
STOCK OPTION PLAN AND STOCK PURCHASE WARRANTS
The Company has adopted Statement of Financial Accounting Standards (SFAS) No.
123, Accounting for Stock-Based Compensation, which permits entities to
recognize as expense over the vesting period the fair value of all stock-based
awards on the date of grant. Alternatively, SFAS No. 123 also allows entities to
continue to apply the provisions of APB Opinion No. 25 for transactions with
employees and provide pro forma disclosures for employee stock option grants as
if the fair value-based method defined in SFAS No. 123 had been applied to these
transactions. The Company has elected to continue to apply the provisions of APB
Opinion No. 25 to these transactions and provide the pro forma disclosure
provisions of SFAS No. 123. Stock purchase warrants granted to non-employees are
recorded at fair value in accordance with SFAS No. 123.
NET LOSS PER SHARE
Statement of Financial Accounting Standards No. 128, "Earnings Per Share" (SFAS)
No. 128, issued February 1997, requires presentation of earnings per share on a
basic and diluted earnings per share basis. Earnings per share for all periods
presented have been stated to reflect the adoption of SFAS No. 128.
Under the provisions of SFAS No. 128, basic earnings per share is calculated as
income available to common shareholders divided by the weighted-average number
of common shares outstanding during the periods. Diluted earnings per share is
based on the weighted-average number of shares of common stock and common stock
equivalents outstanding during the periods, including options and warrants
computed using the treasury stock method.
COMPREHENSIVE INCOME
There are no differences between comprehensive income and net income as reported
in the Company's statements of operations.
F-9
<PAGE> 92
N2H2, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1996, 1997 AND 1998
AND MARCH 31, 1998 AND 1999 (UNAUDITED)
UNAUDITED INTERIM FINANCIAL STATEMENTS
In the opinion of the Company's management, the March 31, 1998 and 1999
unaudited interim financial statements include all adjustments, consisting of
normal recurring adjustments, necessary for a fair presentation of the financial
statements. All references hereinafter to March 31, 1998 and 1999 amounts are
based on unaudited information.
RECENTLY ISSUED ACCOUNTING STANDARDS
In June 1997, the FASB issued Statement of Financial Accounting Standards No.
131, Disclosures About Segments of an Enterprise and Related Information. This
statement supersedes Statement of Financial Accounting Standards No. 14,
Financial Reporting for Segments of a Business Enterprise. This statement
includes requirements to report selected segment information quarterly and
entity-wide disclosures about products and services, major customers, and the
material countries in which the entity holds assets and reports revenues. The
statement will be effective for fiscal years beginning after December 15, 1997.
Reclassification for earlier periods is required, unless impracticable, for
comparative purposes. The Company is currently evaluating the impact this
statement will have on its financial statements; however, because the statement
requires only additional disclosure, the Company does not expect the statement
to have a material impact on its reported financial position or results of
operations.
In March 1998, the Accounting Standards Executive Committee of the American
Institute of Certified Public Accountants issued SOP 98-1, Accounting for the
Costs of Computer Software Developed or Obtained for Internal Use. SOP 98-1
provides guidance for an enterprise on accounting for the costs of computer
software developed or obtained for internal use. SOP 98-1 is effective for the
Company in fiscal 1999. The Company anticipates that accounting for transactions
under SOP 98-1 will not have a material impact on the Company's financial
position or results of operations.
3. PROPERTY AND EQUIPMENT
Property and equipment consists of the following:
<TABLE>
<CAPTION>
SEPTEMBER 30,
---------------------- MARCH 31,
1997 1998 1999
-------- ---------- -----------
(UNAUDITED)
<S> <C> <C> <C>
Computer equipment.............................. $606,000 $1,637,000 $2,402,000
Furniture and fixtures.......................... 14,000 42,000 163,000
Leasehold improvements.......................... 61,000 61,000
Software........................................ 185,000
-------- ---------- ----------
620,000 1,740,000 2,811,000
Less: Accumulated depreciation and
amortization.................................. (167,000) (469,000) (766,000)
-------- ---------- ----------
$453,000 $1,271,000 $2,045,000
======== ========== ==========
</TABLE>
Depreciation expense was approximately $42,000, $125,000 and $322,000 for the
years ended September 30, 1996, 1997 and 1998. Depreciation expense was
approximately $98,000 and $297,000 for the six months ended March 31, 1998 and
1999 (unaudited).
F-10
<PAGE> 93
N2H2, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1996, 1997 AND 1998
AND MARCH 31, 1998 AND 1999 (UNAUDITED)
4. RELATED PARTY TRANSACTIONS
NOTE RECEIVABLE FROM RELATED PARTIES
In September 1998, the Company converted trade accounts receivable of $30,000
from a related party into a note receivable bearing interest at 10.5% per annum.
The note matures in October 1999; however, in the event the note is prepaid
prior to December 31, 1998, the amount due will be equal to 90% of the initial
balance.
5. LONG-TERM DEBT AND NOTES PAYABLE
In 1996, the Company entered into a loan and stock purchase warrant agreement
with a shareholder providing for maximum borrowings of $500,000. The authorized
principal bears interest at 12% per annum payable on October 31, 1999. In
connection with this loan, the Company issued an option to purchase increments
of 2.2% of the Company's authorized common stock for each $100,000 of debt
outstanding. The options, in the aggregate, represent 11% of the Company's
common stock outstanding and are exercisable immediately. The agreement also
includes anti-dilution provisions which provide the shareholder a 25% ownership
interest in the Company. The warrants and the debt were recorded at their fair
market values of $73,000 and $427,000, respectively. The original issue discount
is amortized annually through the maturity date of the debt on a basis which
approximates the interest method. These warrants were equivalent to 727,332 and
1,283,330 and 1,283,330 shares of the Company's common stock at September 30,
1996, 1997 and 1998, respectively. Principal and accrued interest under this
obligation amounted to $594,000, net of original issue discount of $26,000 at
September 30, 1998.
In April 1997, the Company entered into a notes payable agreement with a
shareholder for $400,000 which bears compounded interest at 12% per annum and is
collateralized by the Company's common stock. Principal and accrued interest
under this obligation amounted to $472,000 as of September 30, 1998, and the
note is payable in full on October 31, 1999. The principal and interest on the
note was repaid in full with the proceeds from the Company's debt and equity
financing obtained subsequent to year-end.
The Company issued a promissory note payable to a third party in the amount of
$28,000 which bears interest at 8.5%. The note was issued for consulting
services and is due in monthly installments through October 31, 1999.
In January 1998, the Company issued $100,000 in notes to certain shareholders
which are repayable in either shares of common stock worth $100,000 or cash. The
notes were convertible into shares of common stock if the Company had obtained
additional equity capital of at least $2,000,000 by October 31, 1999. If the
additional equity capital is not obtained, the notes are due with interest of 2%
per month on or before December 31, 1999. Subsequent to year-end, the notes and
accrued interest were converted into 103,675 shares of common stock at $1.16 per
share.
The Company issued a non-interest bearing promissory note payable to a third
party in the amount of $69,000. The note was issued to obtain office space and
is due in monthly installments through October 31, 2000.
Notes payable to shareholder in the amount of $185,000 consists of salary unpaid
at September 30, 1998 due to the shareholder who is also a senior executive. The
note bears interest at 5% and is payable on October 31, 2000 or upon obtaining
an additional equity investment of $2,000,000 or more. The note was paid in full
with proceeds from the Company's debt and equity financing obtained subsequent
to year-end.
F-11
<PAGE> 94
N2H2, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1996, 1997 AND 1998
AND MARCH 31, 1998 AND 1999 (UNAUDITED)
Long term debt and notes payable consist of the following at September 30, 1998:
<TABLE>
<S> <C>
Promissory note to shareholder, due October 31, 1999........ $ 620,000
Promissory note to related parties, due October 31, 1999.... 472,000
Promissory note, due October 31, 1999....................... 28,000
Convertible note to shareholders, due December 31, 1999..... 100,000
Promissory note, due October 31, 2000....................... 69,000
Promissory note to shareholder, due October 31, 2000........ 185,000
----------
1,474,000
Less: Original issue discount............................... (26,000)
Less: Current portion....................................... (30,000)
----------
$1,418,000
==========
</TABLE>
Future maturities on long-term debt and notes payable to related parties and
third parties, excluding the original issue discount, are as follows:
<TABLE>
<CAPTION>
NOTES
DUE TO RELATED NOTES
YEARS ENDED SEPTEMBER 30, SHAREHOLDERS PARTIES PAYABLE TOTAL
- ------------------------- ------------ -------- ------- ----------
<S> <C> <C> <C> <C>
1999................... $30,000 $ 30,000
2000................... $720,000 $472,000 64,000 1,256,000
2001................... 185,000 3,000 188,000
-------- -------- ------- ----------
$905,000 $472,000 $97,000 $1,474,000
======== ======== ======= ==========
</TABLE>
6. FACTORING AGREEMENT
Pursuant to a factoring agreement entered into in September 1997 and amended
July 14, 1998, the Company's bank acts as its factor for the majority of its
receivables, assigned on a pre-approved, full recourse basis, up to $1,000,000.
The Company sells its eligible receivables at a .3% discount to face value and
is charged 1.6% of uncollected assigned balances per month. Pursuant to the
agreement, the Company repurchases any assigned receivables outstanding 90 days
after the invoice date. Total interest paid on factored receivables was $2,000
and $86,000 during 1997 and 1998. In fiscal 1999, the Company terminated its
factoring agreement with the bank.
7. STOCK OPTION PLAN AND STOCK PURCHASE WARRANTS
Pursuant to a management services agreement dated December 29, 1997, the Company
issued a warrant to allow the purchase of 2.5% of the Company's outstanding
common stock and equivalents for $250,000 through December 31, 2004. As of the
grant date, this warrant was the equivalent of 222,728 shares. The warrant vests
monthly over the first year of the agreement, and is exercisable sooner in
connection with certain significant corporate events. The fair market value of
these warrants on the date of grant was $12,000, which is being amortized as
management service expense in the accompanying financial statements over the
vesting period of the warrants. On March 11, 1999, the Company redeemed the
outstanding warrant for 50,000 shares of its common stock, and recorded a
redemption charge of $185,000 in the March 31, 1999 unaudited financial
statements.
F-12
<PAGE> 95
N2H2, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1996, 1997 AND 1998
AND MARCH 31, 1998 AND 1999 (UNAUDITED)
Non-employees were issued 729,833, 555,998 and 222,728 warrants during 1996,
1997 and 1998. The Company recorded compensation expense of $41,000, $32,000 and
$12,000, respectively, relating to these warrants.
Subsequent to year-end, the Company offered to settle a lawsuit with a former
employee terminated in fiscal 1998. In connection with the offer, the Company
extended the exercise period for stock options previously granted to the
employee. The Company recorded compensation expense of $530,000 related to this
transaction in the September 30, 1998 financial statements.
Subsequent to year-end, the Company settled a lawsuit with an employee
terminated in fiscal 1998 for cash and stock with an aggregate value of
$332,000. The Company recorded compensation expense of $277,000 relating to the
75,000 shares issued as a part of this settlement. This charge is included in
the Company's financial statements for the year ended September 30, 1998.
Effective September 30, 1997, the Company adopted the 1997 Stock Option Plan
(the 1997 Plan) for employees, directors, consultants or independent contractors
under which 2,187,500 shares of common stock are reserved for stock option
grants. Pursuant to the Plan, the Board of Directors may grant nonqualified and
incentive stock options. The vesting period, exercise price and expiration
period of options are established at the discretion of the Board of Directors,
except that the exercise price of incentive stock options must equal the fair
market value of the underlying common stock on the date of the grant.
Additionally, in no event shall the term of any incentive stock option exceed
ten years.
The following summarizes the activity under the Company's 1997 and 1999 Stock
Option Plans:
<TABLE>
<CAPTION>
WEIGHTED-
WEIGHTED- AVERAGE
AVERAGE FAIR VALUE
OPTIONS OPTIONS EXERCISE OF OPTIONS
AVAILABLE OUTSTANDING PRICE GRANTED
---------- ----------- --------- ----------
<S> <C> <C> <C> <C>
Options available......................... 2,187,500
Options granted at fair value............. (1,827,438) 1,827,438 $ .19 $ .04
---------- ----------
Balances at September 30, 1997.............. 360,062 1,827,438 .18 .04
Options granted at fair value............. (696,500) 696,500 .25 .05
Options exercised......................... (374,062) .20
Options cancelled......................... 465,938 (465,938) .18
---------- ----------
Balance at September 30, 1998............... 129,500 1,683,938 .21 .04
Options granted at less than fair value
(unaudited)............................ (339,125) 339,125 1.06 1.94
Options exercised (unaudited)............. (122,233) .18
Options cancelled (unaudited)............. 60,000 (60,000) .18
---------- ----------
Balance at March 31, 1999 (unaudited)....... (149,625) 1,840,830 $ .37 $ .08
========== ==========
</TABLE>
F-13
<PAGE> 96
N2H2, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1996, 1997 AND 1998
AND MARCH 31, 1998 AND 1999 (UNAUDITED)
The following table summarizes information about stock options outstanding under
the 1997 Plan at September 30, 1998:
<TABLE>
<CAPTION>
WEIGHTED-
AVERAGE WEIGHTED-
EXERCISE OPTIONS REMAINING OPTIONS AVERAGE
PRICE OUTSTANDING CONTRACT LIFE VESTED FAIR VALUE
-------- ----------- ------------- ------- ----------
<S> <C> <C> <C> <C>
$ .18 1,141,438 9.0 593,950 $ .04
$ .27 542,500 10.0 $ .05
--------- -------
1,683,938 9.3 593,950 $ .04
========= =======
</TABLE>
Option grants to date generally vest over a three-year period, and expire ten
years from the date of grant.
The per share weighted average fair value of stock options granted during 1997
and 1998 was $.04 and $.05, respectively, on the date of grant using the minimum
value pricing model with the following weighted average assumptions: expected
dividend yield of zero; risk-free interest rate of 5.9% and 4.8% for 1997 and
1998, respectively, and an expected life of five years.
The Company applies APB Opinion No. 25 in accounting for its Plan and,
accordingly, compensation cost has been recognized for its stock options in the
financial statements only to the extent that the exercise price of the option is
less than the fair value of the underlying stock on the date of the grant. Had
the Company determined compensation cost based on the fair value at the grant
date for its stock options under SFAS No. 123, the Company's net loss for the
years ended September 30, 1997 and 1998 would have been increased to the pro
forma amounts indicated below:
<TABLE>
<CAPTION>
1997 1998
--------- -----------
<S> <C> <C>
Net loss
As reported...................................... $(881,000) $(2,597,000)
Pro forma........................................ $(881,000) $(2,623,000)
Loss per share
As reported...................................... $ (.10) $ (.30)
Pro forma........................................ $ (.10) $ (.30)
</TABLE>
Pro forma net loss reflects the compensation expense related to options granted
in 1997 and 1998. The full impact of compensation cost for stock options under
SFAS No. 123 is not reflected in the pro forma net loss amount presented above
because compensation cost is amortized over the options' vesting period of three
years.
8. COMMON STOCK
As of September 30, 1998, the Company amended its Articles of Incorporation to
authorize the issuance of 10,000,000 shares of preferred stock and 20,000,000
shares of common stock at no par value. The terms of the preferred shares are to
be set by the Board of Directors.
On September 30, 1997 and September 30, 1998, the Board of Directors declared a
one hundred twenty five to one and a seven to one stock split, respectively, on
the Company's common stock effected in the form of a stock dividend to holders
of record on these dates. Common stock issued and stock option information in
these financial statements have been restated to reflect these splits.
F-14
<PAGE> 97
N2H2, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1996, 1997 AND 1998
AND MARCH 31, 1998 AND 1999 (UNAUDITED)
\9. LEASE COMMITMENTS
The Company's property held under capital leases, which is included in property
and equipment on the balance sheet at September 30, 1997 and 1998, consists
primarily of computer equipment in the gross amount of $64,000, $249,000 and
$1,006,000, respectively. Related accumulated amortization for those assets is
$17,000, $43,000 and $189,000 for the years then ended. The Company is also
committed under operating leases for its headquarter facilities. Rent expense
for the years ended September 30, 1996, 1997 and 1998 was $28,000, $46,000 and
$188,000, respectively.
Minimum annual rental commitments on all leases at September 30, 1998 are as
follows:
<TABLE>
<CAPTION>
OPERATING CAPITAL
YEARS ENDING SEPTEMBER 30, LEASE LEASES
-------------------------- --------- ----------
<S> <C> <C>
1999.......................................... $238,000 $ 384,000
2000.......................................... 232,000 439,000
2001.......................................... 16,000 194,000
2002.......................................... 48,000
2003.......................................... 37,000
-------- ----------
Total minimum lease payments......................... $486,000 1,102,000
========
Less: Amount representing interest................... (194,000)
----------
Present value of capital lease obligation............ 908,000
Less: Current portion................................ (384,000)
----------
Long-term obligations at September 30, 1998.......... $ 524,000
==========
</TABLE>
10. NET LOSS PER SHARE
Statement of Financial Accounting Standards No. 128, "Earnings Per Share" (SFAS)
No. 128, issued in February 1997, requires presentation of earnings per share on
a basic and diluted earnings per share basis. Earnings per share for prior
periods presented have been stated to reflect the adoption of SFAS No. 128. A
reconciliation of the basic and diluted earnings per share to the shares used is
as follows:
<TABLE>
<CAPTION>
SEPTEMBER 30, MARCH 31,
------------------------------------- -------------------------
1996 1997 1998 1998 1999
---------- ---------- ----------- ---------- ------------
(UNAUDITED)
<S> <C> <C> <C> <C> <C>
Net loss...................... $ (827,000) $ (881,000) $(2,597,000) $ (679,000) $ (2,015,000)
Weighted-average shares
outstanding-basic........... 7,316,858 8,389,878 8,687,435 8,686,411 10,758,005
Weighted-effect of dilutive
options and warrants........
---------- ---------- ----------- ---------- ------------
Weighted-average shares
outstanding-diluted......... 7,316,858 8,389,878 8,687,435 8,686,411 10,758,005
========== ========== =========== ========== ============
Basic and diluted net loss per
share....................... $ (.11) $ (.10) $ (.30) $ (.08) $ (.19)
---------- ---------- ----------- ---------- ------------
</TABLE>
F-15
<PAGE> 98
N2H2, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1996, 1997 AND 1998
AND MARCH 31, 1998 AND 1999 (UNAUDITED)
The Company's outstanding options and warrants have not been considered in
calculating diluted earnings per share because their effect is anti-dilutive.
11. COMMITMENTS AND CONTINGENCIES
The Company is from time to time involved in various claims and legal
proceedings of a nature considered by Company management to be routine and
incidental to its business. In the opinion of Company management, after
consultation with outside legal counsel, the ultimate disposition of such
matters is not expected to have a material adverse effect on the Company's
financial position, results of operations or liquidity.
12. SUBSEQUENT EVENTS
On December 31, 1998, the Company received proceeds from a financing arrangement
in the amount of $4,200,000 in exchange for the issuance of subordinated debt
and common stock. The Company issued $2,000,000 of 11.5% subordinated debentures
maturing on the earlier of October 15, 1999, a change in control of the Company,
or upon an initial public offering. In conjunction with the notes, the Company
issued warrants to purchase up to 465,000 shares of common stock at an exercise
price of $3.14 per share. The debt and the warrants have been recorded at their
fair market values of $1,923,000 and $77,000, respectively. The original issue
discount is amortized through the maturity date of the debt on a basis which
approximates the interest method. Additionally, the Company issued 1,687,113
shares of common stock at $1.16 per share, net of offering costs of $.14 per
share. The total proceeds will be used to fund current operations and research
and development projects, and extinguish debt.
As of September 30, 1998, the Company had a $500,000 long term note payable that
had attached the purchase of warrants for up to 11% of the Company's authorized
common stock outstanding with a shareholder. Effective December 31, 1998, the
Company converted the note principal and warrant into 1,632,500 shares of common
stock with an additional warrant to purchase up to 93,000 shares of the
Company's common stock at an exercise price of $.004 per share. The warrant is
subject to cancellation upon an initial public offering.
Effective April 2, 1999, the Company adopted the 1999 Stock Option Plan (the
1999 Plan) for employees, directors, consultants or independent contractors
under which 1,329,625 shares of common stock are reserved for stock option
grants. The new plan terms are comparable to those under the 1997 Plan. As of
March 31, 1999, the Company had granted 150,375 options under the 1999 Plan
pending shareholder approval of the plan on April 2, 1999.
On May 10, 1999 the Board of Directors of the Company approved an amendment to
its Articles of Incorporation to authorize the issuance of 50,000,000 shares of
preferred stock and 250,000,000 shares of common stock at no par value. The
terms of the preferred stock are to be set by the Board of Directors. The
shareholders subsequently approved this amendment on June 11, 1999.
As of May 11, 1999, the Company became a C corporation for income tax reporting
purposes. Previously, it was organized as an S Corporation and as such, the tax
effects were passed directly to the shareholders.
On May 11, 1999, the Company completed a private equity financing in which
2,705,648 shares of common stock were sold to investors at $3.70 per share for
an aggregate of $10,000,129. In connection with this financing, the Company
satisfied a promissory note plus accrued interest totaling $608,186 due to
F-16
<PAGE> 99
N2H2, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
SEPTEMBER 30, 1996, 1997 AND 1998
AND MARCH 31, 1998 AND 1999 (UNAUDITED)
a shareholder in exchange for 164,552 shares of common stock. A $200,000 fee
owed to a placement agency was also satisfied from the proceeds of the private
equity financing.
Effective May 14, 1999, the Board of Directors declared a five-for-two stock
split on the Company's common stock effected in the form of a stock dividend to
holders of record on this date. Common stock issued and stock option information
in these financial statements have been restated to reflect this split.
13. SUBSEQUENT EVENTS (UNAUDITED)
On May 7, 1999, the Company was released from the terms of a management services
agreement dated May 8, 1998 for a fee of $130,000. This fee is recorded in the
Company's financial statements for the third quarter ended June 30, 1999.
14. SUPPLEMENTAL CASH FLOW INFORMATION
Supplemental disclosure of cash flow information is summarized below for the
years ended September 30, 1996, 1997 and 1998, and for the six months ended
March 31, 1998 and 1999:
<TABLE>
<CAPTION>
SIX MONTHS ENDED
YEARS ENDED SEPTEMBER 30, MARCH 31,
----------------------------- -------------------
1996 1997 1998 1998 1999
------- -------- -------- -------- --------
(UNAUDITED)
<S> <C> <C> <C> <C> <C>
Noncash investing and financing
activities:
Equipment obtained through capital
lease............................... $44,000 $185,000 $757,000 $315,000 $655,000
Value ascribed to warrants issued with
note payable........................ 41,000 32,000 77,000
Conversion of notes payable to common
stock............................... 724,000
Notes payable surrendered for the
exercise price of stock options..... 75,000
Cash paid for interest................. 10,000 36,000 178,000 57,000 315,000
</TABLE>
F-17
<PAGE> 100
- --------------------------------------------------------------------------------
[N2H2 LOGO]
N2H2, INC.
4,500,000 SHARES
COMMON STOCK
---------------------------
PROSPECTUS
---------------------------
, 1999
CIBC WORLD MARKETS
U.S. BANCORP PIPER JAFFRAY
- --------------------------------------------------------------------------------
YOU MAY RELY ONLY ON THE INFORMATION CONTAINED IN THIS PROSPECTUS. WE HAVE NOT
AUTHORIZED ANYONE TO PROVIDE PROSPECTIVE INVESTORS WITH DIFFERENT OR ADDITIONAL
INFORMATION FROM THAT CONTAINED IN THIS PROSPECTUS. THIS PROSPECTUS IS NOT AN
OFFER TO SELL NOR IS IT SEEKING AN OFFER TO BUY THESE SECURITIES IN ANY
CIRCUMSTANCES WHERE THE OFFER OR SALE IS UNLAWFUL.
DEALER PROSPECTUS DELIVERY OBLIGATION: UNTIL , 1999 (25 DAYS
AFTER THE DATE OF THIS PROSPECTUS), ALL DEALERS THAT BUY, SELL OR TRADE THESE
SHARES OF COMMON STOCK, WHETHER OR NOT PARTICIPATING IN THIS OFFERING, MAY BE
REQUIRED TO DELIVER A PROSPECTUS. THIS IS IN ADDITION TO THE DEALERS' OBLIGATION
TO DELIVER A PROSPECTUS WHEN ACTING AS UNDERWRITERS AND WITH RESPECT TO THEIR
UNSOLD ALLOTMENTS OR SUBSCRIPTIONS.
<PAGE> 101
PART II
INFORMATION NOT REQUIRED IN PROSPECTUS
ITEM 13. OTHER EXPENSES OF ISSUANCE AND DISTRIBUTION.
Other expenses in connection with the issuance and distribution of the
securities registered by this prospectus, which will be paid by us, will be
substantially as follows:
<TABLE>
<CAPTION>
ITEM AMOUNT
---- --------
<S> <C>
Commission Registration Fee................................. $ 13,900
Nasdaq National Market Fee.................................. 25,000
NASD Filing Fee............................................. 5,500
Blue Sky Fees and Expenses (Including Legal Fees)........... 5,000
Accounting Fees and Expenses................................ 150,000
Legal Fees and Expenses..................................... 275,000
Printing and Engraving...................................... 80,000
Registrar and Transfer Agent Fees........................... 5,000
Miscellaneous Expenses...................................... 31,600
--------
Total.................................................. $630,000
========
</TABLE>
ITEM 14. INDEMNIFICATION OF DIRECTORS AND OFFICERS
Sections 23B.08.500 through 23B.08.600 of the Washington Business Corporation
Act authorize a court to award, or a corporation's board of directors to grant,
indemnification to directors and officers on terms sufficiently broad to permit
indemnification under specified circumstances for liabilities arising under the
Securities Act of 1933, as amended (the "Securities Act"). The directors and
officers of the registrant also may be indemnified against liability they may
incur for serving in those capacities under director and officer insurance
coverage maintained by us for that purpose.
Section 23B.08.320 of the Washington Business Corporations Act authorizes a
corporation to limit a director's liability to the corporation or its
shareholders for monetary damages for acts or omissions as a director, except in
specific circumstances involving intentional misconduct, knowing violations of
law or illegal corporate loans or distributions or any transaction from which
the director personally receives a benefit in money, property or services to
which the director is not legally entitled. Article 12 of our restated articles
of incorporation (Exhibit 3.1 hereto) contains provisions implementing, to the
fullest extent permitted by Washington law, these limitations on a director's
liability to the registrant and its shareholders.
The Underwriting Agreement which is Exhibit 1.1 to this registration statement
provides for indemnification by the underwriters of the registrant and its
executive officers and directors and by the registrant of the underwriters, for
various liabilities, including liabilities arising under the Securities Act, in
connection with matters specifically provided in writing by the underwriters for
inclusion in this registration statement.
ITEM 15. RECENT SALES OF UNREGISTERED SECURITIES
In the three year period up to July 7, 1999, we have issued and sold
unregistered securities as follows:
On July 31, 1996, we entered into a Loan and Stock Option Agreement with The
Segale Group, a Washington general partnership, of which Mr. Segale, currently a
director and 5% shareholder of ours, was managing partner. As of December 31,
1998, the outstanding loan balance under the Loan and Stock
II-1
<PAGE> 102
Option Agreement was $500,000. Under a Loan Conversion Agreement dated April 8,
1999, and dated effective as of December 31, 1998, we issued 1,632,500 shares of
common stock and warrants to purchase 93,000 shares of common stock at a price
per share of $.004 per share to Mr. Segale, Lisa M. Atkins, Tina A. Covey, Nita
S. Johnson, Ann J. Nichols, Donna A. Segale and Samir J. Tuma, all partners in
The Segale Group. We have included the Segale partners' offer to sell shares of
common stock at an aggregate offering price of $500,000 under this prospectus,
and therefore these warrants will be cancelled upon completion of this offering.
On December 28, 1997, we issued warrants to purchase 222,728 shares of our
common stock at $1.12 per share to Madrona Group, LLP. On March 11, 1999, we
redeemed and cancelled the warrants in exchange for 50,000 shares of common
stock issued to Madrona Group, LLP, which issuance was ratified on May 10, 1999.
In January 1998, Eileen Johnston, John Narver, and Peter Nickerson and Hollis
Hill loaned $25,000, $25,000 and $50,000, respectively, to us, represented by
convertible promissory notes. On December 31, 1998, we converted these notes,
plus accrued interest, into shares of common stock at per share price of $1.18
as follows: (a) 25,887 shares of common stock to Ms. Johnston for an aggregate
of $30,671, (b) 25,845 shares of common stock to Mr. Narver for an aggregate of
$30,621 and (c) 51,942 shares of common stock to Mr. Nickerson and Ms. Hill for
an aggregate of $61,540.
On December 31, 1998, we issued and sold an aggregate of 500,000 shares of
common stock to Peter Nickerson and Hollis Hill, a marital community, at a
purchase price of $1.18 per share, or an aggregate of $592,000.
On December 31, 1998, we entered into a Securities Purchase Agreement under
which we issued and sold an aggregate of 1,157,975 shares of common stock to six
investors, James Stearns, Glen Powers, the Dann Angeloff TTEE FBO Angeloff
Family Trust, the Dann Angeloff TTEE UTD Trust, The Cruttenden Roth Bridge Fund,
LLC and Robert London, at a purchase price of $1.16 per share, net of
commissions paid by us, or an aggregate of $343,251. In addition, we issued
warrants to purchase 392,085 shares of common stock at a per share price of
$3.14 per share to these investors. These investors also loaned us $1,686,364
represented by convertible promissory notes.
On January 28, 1999, under an Amendment No. 1 to the Securities Purchase
Agreement dated December 31, 1997, we issued and sold an aggregate of 529,138
shares of common stock to 12 investors, Shelly Singhal, Joel Slutzky, Alan
Slutzky, Gregory Miner, Michael Erickson, William Foley, Frank Willey, Gary
Nelson, Thomas Rakow, John Narver, Phillip Dinapoli Jr. and Gary Cremo at a
purchase price of $1.16 per share, net of commissions paid by us, or an
aggregate of $613,802. In addition, we issued warrants to purchase 72,915 shares
of common stock at a per share price of $3.14 per share to these investors.
These investors also loaned us $313,636 represented by convertible promissory
notes.
On January 28, 1999, we issued and sold 937 shares of common stock to Peter
Nickerson at a purchase price of $1.18 per share, or an aggregate of $1,110.
On April 2, 1999, we issued 149,625 shares of our common stock to Sid Swartz
pursuant to a Settlement Agreement and Release.
On April 12, 1999, we issued 75,000 shares of our common stock to Jennifer
Perenchio under a Settlement Agreement and General Release.
On April 23, 1999, under a Rescission and Sale Agreement by and among Thomas
Rakow, Monte Brem and us, Mr. Rakow rescinded the purchase of (a) 2,555 shares
of common stock out of the 7,668 he had purchased on January 28, 1999 and(b)
warrants to purchase 350 shares of common stock out of the warrants to purchase
1,050 shares of common stock he had purchased on January 28, 1999. We paid Mr.
Rakow an aggregate of $5,000 for the rescinded shares of common stock and
warrants to purchase common stock. Under the same agreement, Monte Brem
purchased 2,555 shares of common stock and warrants to purchase 350 shares of
common stock from us for an aggregate of $5,000.
II-2
<PAGE> 103
On May 11, 1999, we completed a private equity financing in which we sold
2,705,648 shares of common stock to investors at a purchase price of $3.70 per
share for an aggregate of $10,000,129 to 66 purchasers. Among the investors was
Robert London, an owner of over 5% of our common stock, who purchased 435,115
shares of common stock for an aggregate of $1,608,185.
On July 1, 1999 Dann Angeloff TTEE FBO Angeloff Family Trust and Dann Angeloff
TTEE UDT Trust exercised a warrant to purchase an aggregate of 4,580 shares of
common stock.
From September 1997, date of the first issuance of options under our 1997 Stock
Option Plan, through July 7, we granted stock options under the 1997 Plan to
purchase an aggregate 2,712,686 shares of common stock, with exercise prices
ranging from $0.18 to $1.16 per share, to employees, consultants and directors
under our 1997 and 1999 Stock Option Plans. Under our 1999 Stock Option Plan, we
have granted stock options to purchase 1,323,499 shares of common stock, with
exercise prices ranging from $3.06 to $3.70 per share to employees, consultants
and directors. Of the total options granted under these plans, options for an
aggregate of 701,749 shares have been exercised, options for an aggregate of
728,272 shares have vested and are outstanding, options for an aggregate of
525,938 have been cancelled, and options for an aggregate of 2,799,749 shares
remain outstanding. The sales and issuances of these securities were exempt from
registration under the Securities Act under Rule 701 promulgated thereunder on
the basis that these options were offered and sold either under a written
compensatory benefit plan or pursuant to written contracts relating to
consideration, as provided by Rule 701.
All references to common stock in this Item 15 reflect a 125-for-1 common stock
split which occurred on September 30, 1997, a 7-for-1 common stock split which
occurred on September 30, 1998, and a 5-for-2 common stock split which occurred
on July 8, 1999.
Unless otherwise indicated, the issuances and sales of common stock and warrants
described above were exempt under the Securities Act in reliance upon Section
4(2) of the Securities Act or Regulation D promulgated thereunder. The
recipients of securities in each such transaction represented their intentions
to acquire the securities for investment only and not with a view to or for sale
in connection with any distribution thereof and appropriate legends were affixed
to the share certificates issued in such transactions. All recipients had
adequate access to information about us.
II-3
<PAGE> 104
ITEM 16A. EXHIBITS.
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION OF EXHIBIT
- ------- ----------------------
<C> <S>
1.1 Form of Underwriting Agreement.
3.1+ Form of Restated Articles of Incorporation of the
registrant.
3.2+ Amended Bylaws of the registrant.
4.1+ Form of common stock certificate.
5.1+ Opinion of Lane Powell Spears Lubersky LLP regarding
legality of the shares.
10.1+ Bank of California Center Lease dated August 31, 1995,
between Continental Seattle Partners Limited Partnership and
Toll-Free Cellular Inc.
10.2+ Assignment of Lease dated March 13, 1998, between
Continental Seattle Partners Limited. Partnership, Toll-Free
Cellular Inc. and the registrant
10.3+ Union Bank of California Center Office Lease dated March 12,
1999, between Walton Seattle Investors I, L.L.C. and the
registrant.
10.4+ Loan and Security Agreement dated April 30, 1999, between
Imperial Bank and the registrant, together with exhibits
thereto.
10.5+ 1997 Stock Option Plan, as amended.
10.6+ 1999 Stock Option Plan.
10.7+ 1999 Nonemployee Director Stock Option Plan.
10.8+ Search Engine Services Agreement dated January 19, 1998,
between Inktomi Corporation and the registrant (Information
has been omitted pursuant to a request for confidential
treatment and has been filed separately with the Securities
and Exchange Commission).
10.9+ Employment Agreement of Peter H. Nickerson dated May 10,
1999.
10.10+ Employment Agreement of John F. Duncan dated May 10, 1999.
10.11+ Employment Agreement of Kevin E. Fink dated May 10, 1999.
10.12+ Registration Rights Agreement dated effective as of December
31, 1998.
10.13+ Warrant to Purchase Common Stock issued to Mark A. Segale,
for the community of him and Keri D. Segale, on December 31,
1998.
10.14+ Form of Lock-Up Agreement.
10.15+ Internet Data Center Services Agreement dated effective
August 31, 1998, between Exodus Communications, Inc. and the
registrant. (Information has been omitted pursuant to a
request for confidential treatment and has been filed
separately with the Securities and Exchange Commission).
10.16+ Amendment Agreement entered into June 30, 1999, to the
Search Engine Services Agreement dated January 19, 1999,
between Inktomi Corporation and the registrant (Information
has been omitted pursuant to a request for confidential
treatment and has been filed separately with the Securities
and Exchange Commission).
10.17+ Information Services Agreement dated June 30, 1999, between
Inktomi Corporation and the registrant (Information has been
omitted pursuant to a request for confidential treatment and
has been filed separately with the Securities and Exchange
Commission).
23.1 Consent of PricewaterhouseCoopers, LLP, Independent
Accountants.
23.2+ Consent of Lane Powell Spears Lubersky LLP (contained in the
opinion filed as Exhibit 5.1 hereto).
23.3+ Consent of Quality Education Data, Inc.
23.4+ Consent of Seed and Berry LLP.
24.1+ Power of Attorney (contained on signature page).
</TABLE>
- ---------------------------
+ Previously Filed
II-4
<PAGE> 105
ITEM 16b. FINANCIAL STATEMENT SCHEDULE.
All schedules for which provision is made in the applicable accounting
regulations of the Securities and Exchange Commission are not required under the
related instructions, are inapplicable or not material, or the information
called for thereby is otherwise included in the financial statements and
therefore has been omitted.
ITEM 17. UNDERTAKINGS.
Insofar as indemnification for liabilities arising under the Securities Act may
be permitted to directors, officers and controlling persons of the registrant
pursuant to the foregoing provisions or otherwise, the registrant has been
advised that in the opinion of the commission such indemnification is against
public policy as expressed in the Securities Act and is, therefore,
unenforceable. In the event that a claim for indemnification against such
liabilities (other than the payment by the registrant of expenses incurred or
paid by a director, officer or controlling person of the registrant in the
successful defense of any action, suit or proceeding) is asserted by such
director, officer or controlling person in connection with the securities being
registered in the offering, the registrant will, unless in the opinion of its
counsel the matter has been settled by controlling precedent, submit to a court
of appropriate jurisdiction the question whether such indemnification by it is
against public policy as expressed in the Securities Act an will be governed by
the final adjudication of such issue.
The undersigned registrant hereby undertakes to provide to the Underwriters at
the closing in the Underwriting Agreement certificates in such denomination and
registered in such names as required by the Underwriters to permit prompt
delivery to each purchaser.
II-5
<PAGE> 106
The undersigned registrant hereby undertakes that:
(1) For the purposes of determining any liability under the Securities Act,
the information omitted from the form of prospectus filed as part of
this registration statement in reliance upon Rule 430A and contained in
a form of prospectus filed by the registrant pursuant to Rules
424(b)(1) or (4) or 497(h) under the Securities Act, shall be deemed to
be part of this registration statement as of the time it was declared
effective.
(2) For the purposes of determining any liability under the Securities Act,
each post effective amendment that contains a form of prospectus shall
be deemed to be a new registration statement relating to the securities
offered therein and the offering of such securities at that time shall
be deemed to be the initial bona fide offering thereof.
II-6
<PAGE> 107
SIGNATURES
Pursuant to the requirements of the Securities Act of 1933, as amended, the
registrant has duly caused this Amendment No. 3 to the registration statement to
be signed on its behalf by the undersigned, thereunto duly authorized, in the
City of Seattle, State of Washington, on the 20th day of July, 1999.
N2H2, Inc.
By *
------------------------------------
Peter H. Nickerson,
President and Chief Executive
Officer
Pursuant to the requirements of the Securities Act of 1933, as amended, this
Amendment No. 3 to the registration statement has been signed by the following
persons in the capacities indicated below on the 20th day of July 1999.
<TABLE>
<CAPTION>
SIGNATURE TITLE
--------- -----
<C> <S>
* President, Chief Executive Officer and Chairman
- ------------------------------------------------ of the Board of Directors
Peter H. Nickerson
/s/ JOHN F. DUNCAN Vice President -- Chief Financial Officer
- ------------------------------------------------
John F. Duncan
* Director
- ------------------------------------------------
Hollis R. Hill
* Director
- ------------------------------------------------
Mark A. Segale
* By: /s/ JOHN F. DUNCAN
- ------------------------------------------------
John F. Duncan
(Attorney-in-Fact)
</TABLE>
II-7
<PAGE> 108
EXHIBIT INDEX
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION OF EXHIBIT
- ------- ----------------------
<C> <S>
1.1 Form of Underwriting Agreement.
3.1+ Form of Restated Articles of Incorporation of the
registrant.
3.2+ Amended Bylaws of the registrant.
4.1+ Form of common stock certificate.
5.1+ Opinion of Lane Powell Spears Lubersky LLP regarding
legality of the shares.
10.1+ Bank of California Center Lease dated August 31, 1995,
between Continental Seattle Partners Limited Partnership and
Toll-Free Cellular Inc.
10.2+ Assignment of Lease dated March 13, 1998, between
Continental Seattle Partners Limited. Partnership, Toll-Free
Cellular Inc. and the registrant
10.3+ Union Bank of California Center Office Lease dated March 12,
1999, between Walton Seattle Investors I, L.L.C. and the
registrant.
10.4+ Loan and Security Agreement dated April 30, 1999, between
Imperial Bank and the registrant, together with exhibits
thereto.
10.5+ 1997 Stock Option Plan, as amended.
10.6+ 1999 Stock Option Plan.
10.7+ 1999 Nonemployee Director Stock Option Plan.
10.8+ Search Engine Services Agreement dated January 19, 1998,
between Inktomi Corporation and the registrant (Information
has been omitted pursuant to a request for confidential
treatment and has been filed separately with the Securities
and Exchange Commission).
10.9+ Employment Agreement of Peter H. Nickerson dated May 10,
1999.
10.10+ Employment Agreement of John F. Duncan dated May 10, 1999.
10.11+ Employment Agreement of Kevin E. Fink dated May 10, 1999.
10.12+ Registration Rights Agreement dated effective as of December
31, 1998.
10.13+ Warrant to Purchase Common Stock issued to Mark A. Segale,
for the community of him and Keri D. Segale, on December 31,
1998.
10.14+ Form of Lock-Up Agreement.
10.15+ Internet Data Center Services Agreement dated effective
August 31, 1998, between Exodus Communications, Inc. and the
registrant. (Information has been omitted pursuant to a
request for confidential treatment and has been filed
separately with the Securities and Exchange Commission).
10.16+ Amendment Agreement entered into June 30, 1999, to the
Search Engine Services Agreement dated January 19, 1999,
between Inktomi Corporation and the registrant (Information
has been omitted pursuant to a request for confidential
treatment and has been filed separately with the Securities
and Exchange Commission).
10.17+ Information Services Agreement dated June 30, 1999, between
Inktomi Corporation and the registrant (Information has been
omitted pursuant to a request for confidential treatment and
has been filed separately with the Securities and Exchange
Commission).
23.1 Consent of PricewaterhouseCoopers, LLP, Independent
Accountants.
23.2+ Consent of Lane Powell Spears Lubersky LLP (contained in the
opinion filed as Exhibit 5.1 hereto).
23.3+ Consent of Quality Education Data, Inc.
23.4+ Consent of Seed and Berry LLP.
24.1+ Power of Attorney (contained on signature page).
</TABLE>
- ---------------------------
+ Previously Filed
<PAGE> 1
4,500,000 Shares
N2H2, Inc.
Common Stock
FORM OF UNDERWRITING AGREEMENT
July __, 1999
CIBC World Markets Corp.
U.S. Bancorp Piper Jaffray, Inc.
c/o CIBC World Markets Corp.
One World Financial Center
New York, New York 10281
On behalf of the Several
Underwriters named on
Schedule I attached hereto.
Ladies and Gentlemen:
N2H2, Inc., a Washington corporation (the "Company"), and the
shareholders of the Company named in Schedule II to this Agreement (the "Selling
Shareholders," which term shall include, except where otherwise noted, that
certain shareholder of the Company named as the "Affiliated Selling Shareholder"
in Schedule II hereto) severally propose, subject to the terms and conditions
contained herein, to sell to you and the other underwriters named on Schedule I
to this Agreement (the "Underwriters"), for whom you are acting as
Representatives (the "Representatives"), an aggregate of 4,500,000 shares (the
"Firm Shares") of the Company's Common Stock, no par value (the "Common Stock").
Of the Firm Shares, 4,450,000 are to be issued and sold by the Company and
50,000 are to be sold by the Selling Shareholders. The respective amounts of the
Firm Shares to be purchased by each of the several Underwriters are set forth
opposite their names on Schedule I hereto. In addition, the Company proposes to
grant to the Underwriters an option to purchase up to an additional 675,000
shares (the "Option Shares") of Common Stock from it for the purpose of covering
over-allotments in connection with the sale of the Firm Shares. The Firm Shares
and the Option Shares are together called the "Shares."
1. SALE AND PURCHASE OF THE SHARES.
On the basis of the representations, warranties and agreements contained
in, and subject to the terms and conditions of, this Agreement:
(a) The Company agrees to issue and sell to each of the
Underwriters, and each of the Underwriters agrees, severally and not jointly, to
purchase from the Company, at a price of $_____ per share (the "Initial Price"),
the number of Firm Shares set forth opposite the name of such Underwriter under
the column "Number of Firm Shares to be Purchased from the
1.
<PAGE> 2
Company" on Schedule I to this Agreement, subject to adjustment in accordance
with Section 11 hereof. The Selling Shareholders agree to sell to each of the
Underwriters, and each of the Underwriters agrees, severally and not jointly, to
purchase from the Selling Shareholders, at the "Initial Price", the number of
Firm Shares set forth opposite the name of such Underwriter under the column
"Number of Firm Shares to be Purchased from the Selling Shareholders" on
Schedule I to this Agreement, subject to adjustment in accordance with Section
11 hereof.
(b) The Company grants to the several Underwriters an option to
purchase, severally and not jointly, all or any part of the Option Shares at the
Initial Price. The number of Option Shares to be purchased by each Underwriter
shall be the same percentage (adjusted by the Representatives to eliminate
fractions) of the total number of Option Shares to be purchased by the
Underwriters as such Underwriter is purchasing of the Firm Shares. Such option
may be exercised only to cover over-allotments in the sales of the Firm Shares
by the Underwriters and may be exercised in whole or in part at any time on or
before 12:00 noon, New York City time, on the business day before the Firm
Shares Closing Date (as defined below), and from time to time thereafter within
30 days after the date of this Agreement, in each case upon written or
telegraphic notice, or verbal or telephonic notice confirmed by written or
telegraphic notice, by the Representatives to the Company no later than 12:00
noon, New York City time, on the business day before the Firm Shares Closing
Date or at least two and no more than three business days before the Option
Shares Closing Date (as defined below), as the case may be, setting forth the
number of Option Shares to be purchased and the time and date (if other than the
Firm Shares Closing Date) of such purchase.
2. DELIVERY AND PAYMENT. Delivery by the Company and the Selling
Shareholders of the Firm Shares to the Representatives for the respective
accounts of the Underwriters, and payment of the purchase price by certified or
official bank check or checks payable in New York Clearing House (same day)
funds drawn to the order of the Company for the shares purchased from the
Company and to the Selling Shareholders for the shares purchased from the
Selling Shareholders, against delivery of the respective certificates therefor
to the Representatives, shall take place at the offices of CIBC World Markets
Corp., at CIBC World Markets Tower, World Financial Center, New York, New York
10281, at 10:00 a.m., New York City time, on the third business day following
the date of this Agreement, or at such time on such other date, not later than
10 business days after the date of this Agreement, as shall be agreed upon by
the Company and the Representatives (such time and date of delivery and payment
are called the "Firm Shares Closing Date").
In the event the option with respect to the Option Shares is exercised,
delivery by the Company of the Option Shares to the Representatives for the
respective accounts of the Underwriters and payment of the purchase price by
certified or official bank check or checks payable in New York Clearing House
(same day) funds to the Company shall take place at the offices of CIBC World
Markets Corp. specified above at the time and on the date (which may be the same
date as, but in no event shall be earlier than, the Firm Shares Closing Date)
specified in the notice referred to in Section 1(b) (such time and date of
delivery and payment are called the "Option Shares Closing Date"). The Firm
Shares Closing Date and the Option Shares Closing Date are called, individually,
a "Closing Date" and, together, the "Closing Dates."
2.
<PAGE> 3
Certificates evidencing the Shares shall be registered in such names and
shall be in such denominations as the Representatives shall request at least two
full business days before the Firm Shares Closing Date or, in the case of Option
Shares, on the day of notice of exercise of the option as described in Section
l(b) and shall be made available to the Representatives for checking and
packaging, at such place as is designated by the Representatives, on the full
business day before the Firm Shares Closing Date (or the Option Shares Closing
Date in the case of the Option Shares).
3. REGISTRATION STATEMENT AND PROSPECTUS; PUBLIC OFFERING. The Company
has prepared and filed in conformity with the requirements of the Securities Act
of 1933, as amended (the "Securities Act"), and the published rules and
regulations thereunder (the "Rules") adopted by the Securities and Exchange
Commission (the "Commission") a Registration Statement (as hereinafter defined)
on Form S-1 (No. 333-78495), including a preliminary prospectus relating to the
Shares, and such amendments thereof as may have been required to the date of
this Agreement. Copies of such Registration Statement (including all amendments
thereof) and of the related Preliminary Prospectus (as hereinafter defined) have
heretofore been delivered by the Company to you. The term "Preliminary
Prospectus" means any preliminary prospectus (as described in Rule 430 of the
Rules) included at any time as a part of the Registration Statement or filed
with the Commission by the Company with the consent of the Representatives
pursuant to Rule 424(a) of the Rules. The term "Registration Statement" as used
in this Agreement means the initial registration statement (including all
exhibits and financial schedules), as amended at the time and on the date it
becomes effective (the "Effective Date") and as thereafter amended by post
effective amendments. If the Company has filed an abbreviated registration
statement to register additional Shares pursuant to Rule 462(b) under the Rules
(the "462(b) Registration Statement") then any reference herein to the
Registration Statement shall also be deemed to include such 462(b) Registration
Statement. The term "Prospectus" as used in this Agreement means the prospectus
in the form included in the Registration Statement at the time of effectiveness
or, if Rule 430A of the Rules is relied on, the term Prospectus shall also
include the final prospectus filed with the Commission pursuant to Rule 424(b)
of the Rules.
The Company and the Selling Shareholders understand that the
Underwriters propose to make a public offering of the Shares, as set forth in
and pursuant to the Prospectus, as soon after the Effective Date and the date of
this Agreement as the Representatives deem advisable. The Company and the
Selling Shareholders hereby confirm that the Underwriters and dealers have been
authorized to distribute or cause to be distributed each Preliminary Prospectus
and are authorized to distribute the Prospectus (as from time to time amended or
supplemented if the Company furnishes amendments or supplements thereto to the
Underwriters).
4. REPRESENTATIONS AND WARRANTIES OF THE COMPANY. The Company hereby
represents and warrants to each Underwriter as follows:
(a) On the Effective Date, the Registration Statement complied,
and on the date of the Prospectus, the date any post-effective amendment to the
Registration Statement becomes effective, the date any supplement or amendment
to the Prospectus is filed with the Commission and each Closing Date, the
Registration Statement and the Prospectus (and any amendment thereof or
supplement thereto) will comply, in all material respects, with the applicable
provisions of the Securities Act and the Rules and the Securities Exchange Act
of
3.
<PAGE> 4
1934, as amended (the "Exchange Act"), and the rules and regulations of the
Commission thereunder. The Registration Statement did not, as of the Effective
Date, contain any untrue statement of a material fact or omit to state any
material fact required to be stated therein or necessary in order to make the
statements therein not misleading; and on the other dates referred to above
neither the Registration Statement nor the Prospectus, nor any amendment thereof
or supplement thereto, will contain any untrue statement of a material fact or
will omit to state any material fact required to be stated therein or necessary
in order to make the statements therein not misleading. When any related
preliminary prospectus was first filed with the Commission (whether filed as
part of the Registration Statement or any amendment thereto or pursuant to Rule
424(a) of the Rules) and when any amendment thereof or supplement thereto was
first filed with the Commission, such preliminary prospectus as amended or
supplemented complied in all material respects with the applicable provisions of
the Securities Act and the Rules and did not contain any untrue statement of a
material fact or omit to state any material fact required to be stated therein
or necessary in order to make the statements therein not misleading.
Notwithstanding the foregoing, none of the representations and warranties in
this paragraph 4(a) shall apply to statements in, or omissions from, the
Registration Statement or the Prospectus made in reliance upon, and in
conformity with, information herein or otherwise furnished in writing by the
Representatives on behalf of the several Underwriters for use in the
Registration Statement or the Prospectus. With respect to the preceding
sentence, the Company acknowledges that the only information furnished in
writing by the Representatives on behalf of the several Underwriters for use in
the Registration Statement or the Prospectus is the paragraph with respect to
stabilization on the inside front cover page of the Prospectus and the
statements contained under the caption "Underwriting" in the Prospectus.
(b) The Registration Statement is effective under the Securities
Act and no stop order preventing or suspending the effectiveness of the
Registration Statement or suspending or preventing the use of the Prospectus has
been issued and no proceedings for that purpose have been instituted or are
threatened under the Securities Act; any required filing of the Prospectus and
any supplement thereto pursuant to Rule 424(b) of the Rules has been or will be
made in the manner and within the time period required by such Rule 424(b).
(c) The financial statements of the Company (including all notes
and schedules thereto) included in the Registration Statement and Prospectus
present fairly the financial position, the results of operations, the statements
of cash flows and the statements of shareholders' equity and the other
information purported to be shown therein of the Company at the respective dates
and for the respective periods to which they apply; and such financial
statements and related schedules and notes have been prepared in conformity with
generally accepted accounting principles, consistently applied throughout the
periods involved, and all adjustments necessary for a fair presentation of the
results for such periods have been made. The summary and selected financial data
included in the Prospectus present fairly the information shown therein as at
the respective dates and for the respective periods specified and the summary
and selected financial data have been presented on a basis consistent with the
consolidated financial statements so set forth in the Prospectus and other
financial information. No other financial statements or supporting schedules are
required to be included in the Registration Statement. The financial data set
forth in the Prospectus under the captions "Prospectus Summary Financial Data,"
"Selected Financial Data," "Management's Discussion and Analysis of Financial
Conditions and Results of Operations" and "Capitalization" fairly present the
4.
<PAGE> 5
information set forth therein on a basis consistent with that of the audited
financial statements contained in the Registration Statement.
(d) PricewaterhouseCoopers LLP whose reports are filed with the
Commission as a part of the Registration Statement, are and, during the periods
covered by their reports, were independent public accountants as required by the
Securities Act and the Rules.
(e) The Company is a corporation duly organized, validly existing
and in good standing under the laws of the State of Washington. The Company has
no subsidiary or subsidiaries and does not control, directly or indirectly, any
corporation, partnership, joint venture, association or other business
organization. The Company is duly qualified to do business and is in good
standing as a foreign corporation in each jurisdiction in which the nature of
the business conducted by it or location of the assets or properties owned,
leased or licensed by it requires such qualification, except for such
jurisdictions where the failure to so qualify would not have a material adverse
effect on the assets or properties, business, results of operations or financial
condition of the Company (a "Material Adverse Effect"). The Company has all
requisite corporate power and authority, and all necessary authorizations,
approvals, consents, orders, licenses, certificates and permits of and from all
governmental or regulatory bodies or any other person or entity (collectively,
the "Permits"), to own, lease and license its assets and properties and conduct
its business, all of which are valid and in full force and effect, as described
in the Registration Statement and the Prospectus, except where the lack of such
Permits would not have a Material Adverse Effect; the Company has fulfilled and
performed in all material respects all its material obligations with respect to
such Permits and no event has occurred that allows, or after notice or lapse of
time would allow, revocation or termination thereof or results in any other
material impairment of the rights of the Company thereunder. Except as may be
required under the Securities Act and state and foreign Blue Sky laws, no other
Permits are required to enter into, deliver and perform this Agreement and to
issue and sell the Shares (including registration of the Shares under the
Securities Act, listing of the shares on the National Association of Securities
Dealers Automated Quotation ("Nasdaq") National Market System and such Permits
as may be required).
(f) The Company owns or possesses adequate and enforceable rights
to use all trademarks, trademark applications, trade names, service marks,
copyrights, copyright applications, licenses, know-how and other similar rights
and proprietary knowledge (collectively, "Intangibles") described in the
Prospectus as being owned by it and necessary for the conduct of its business.
The Company has not received any notice of, or is not aware of, any infringement
of or conflict with asserted rights of others with respect to any Intangibles,
except as described in the Prospectus.
(g) The Company has good and marketable title in fee simple to
all items of real property and good and marketable title to all personal
property described in the Prospectuses as being owned by it and any real
property and buildings described in the Prospectuses as being held under lease
by the Company is held by it under valid, existing and enforceable leases, free
and clear of all liens, encumbrances, claims, security interests and defects,
except such as are described in the Registration Statement and the Prospectus or
would not have a Material Adverse Effect.
5.
<PAGE> 6
(h) There are no litigation or governmental proceedings to which
the Company is subject or which is pending or, to the knowledge of the Company,
threatened, against the Company, which might have a Material Adverse Effect,
affect the consummation of this Agreement or which is required to be disclosed
in the Registration Statement and the Prospectus that is not so disclosed.
(i) Subsequent to the respective dates as of which information is
given in the Registration Statement and the Prospectus, except as described
therein, (a) there has not been any material adverse change with regard to the
assets or properties, business, results of operations or financial condition of
the Company; (b) the Company has not sustained any loss or interference with its
assets, businesses or properties (whether owned or leased) from fire, explosion,
earthquake, flood or other calamity, whether or not covered by insurance, or
from any labor dispute or any court or legislative or other governmental action,
order or decree which would have a Material Adverse Effect; and (c) since the
date of the latest balance sheet included in the Registration Statement and the
Prospectus, except as described or reflected therein, the Company has not (i)
issued any securities or incurred any liability or obligation, direct or
contingent, for borrowed money, except such liabilities or obligations incurred
in the ordinary course of business, (ii) entered into any transaction not in the
ordinary course of business or (iii) declared or paid any dividend or made any
distribution on any shares of its stock or redeemed, purchased or otherwise
acquired or agreed to redeem, purchase or otherwise acquire any shares of its
stock.
(j) There is no document, contract or other agreement of a
character required to be described in the Registration Statement or Prospectus
or to be filed as an exhibit to the Registration Statement which is not
described or filed as required by the Securities Act or Rules. Each description
of a contract, document or other agreement in the Registration Statement and the
Prospectus accurately reflects in all material respects the terms of the
underlying document, contract or agreement. Each agreement described in the
Registration Statement and Prospectus or listed in the Exhibits to the
Registration Statement is in full force and effect and is valid and enforceable
by and against the Company in accordance with its terms. Neither the Company
nor, to the Company's knowledge, any other party is in default in the observance
or performance of any term or obligation to be performed by it under any such
agreement, and no event has occurred which with notice or lapse of time or both
would constitute such a default, in any such case which default or event would
have a Material Adverse Effect. No default exists, and no event has occurred
which with notice or lapse of time or both would constitute a default, in the
due performance and observance of any term, covenant or condition, by the
Company of any other agreement or instrument to which the Company is a party or
by which it or its properties or business may be bound or affected which default
or event would have a Material Adverse Effect.
(k) The Company is not in violation of any term or provision of
its charter or by-laws or of any franchise, license, permit, judgment, decree,
order, statute, rule or regulation, where the consequences of such violation
would have a Material Adverse Effect.
(l) Neither the execution, delivery and performance of this
Agreement nor the consummation of any of the transactions contemplated hereby
(including, without limitation, the issuance and sale by the Company of the
Shares) will give rise to a right to terminate or accelerate the due date of any
payment due under, or conflict with or result in the breach of any
6.
<PAGE> 7
term or provision of, or constitute a default (or an event which with notice or
lapse of time or both would constitute a default) under, or require any consent
or waiver under, or result in the execution or imposition of any lien, charge or
encumbrance upon any properties or assets of the Company pursuant to the terms
of, any indenture, mortgage, deed of trust or other agreement or instrument to
which the Company is a party or by which it or any of its properties or
businesses is bound, or any franchise, license, permit, judgment, decree, order,
statute, rule or regulation applicable to the Company or violate any provision
of the charter or by-laws of the Company, except for such consents or waivers
which have already been obtained and are in full force and effect.
(m) The Company has authorized and outstanding capital stock as
set forth under the caption "Capitalization" in the Prospectus. The certificates
evidencing the Shares are in due and proper legal form and have been duly
authorized for issuance by the Company. All of the issued and outstanding shares
of Common Stock have been duly and validly issued and are fully paid and
nonassessable. There are no statutory preemptive or other similar rights to
subscribe for or to purchase or acquire any shares of Common Stock of the
Company or any such rights pursuant to its Articles of Incorporation or by-laws
or any agreement or instrument to or by which the Company is a party or bound.
The Shares, when issued and sold pursuant to this Agreement will be duly and
validly issued, fully paid and nonassessable and none of them will be issued in
violation of any preemptive or other similar right. Except as disclosed in the
Registration Statement and the Prospectus, there is no outstanding option,
warrant or other right calling for the issuance of, and there is no commitment,
plan or arrangement to issue, any share of stock of the Company or any security
convertible into, or exercisable or exchangeable for, such stock. The Common
Stock and the Shares conform in all material respects to all statements in
relation thereto contained in the Registration Statement and the Prospectus.
(n) Except as described in the Prospectus, no holder of any
security of the Company has the right to have any security owned by such holder
included in the Registration Statement or to demand registration of any security
owned by such holder during the period ending 180 days after the date of this
Agreement. Except as agreed to by CIBC World Markets Corp., each shareholder,
director and executive officer of the Company has delivered to the
Representatives his enforceable written lock-up agreement in the form attached
to this Agreement ("Lock-Up Agreement").
(o) All necessary corporate action has been duly and validly
taken by the Company to authorize the execution, delivery and performance of
this Agreement and the issuance and sale of the Shares by the Company. This
Agreement has been duly and validly authorized, executed and delivered by the
Company and constitute and will constitute legal, valid and binding obligations
of the Company enforceable against the Company in accordance with their
respective terms, except (i) as the enforceability thereof may be limited by
bankruptcy, insolvency, reorganization, moratorium or other similar laws
affecting the enforcement of creditors' rights generally and by general
equitable principles and (ii) to the extent that rights to indemnity or
contribution under this Agreement may be limited by Federal and state securities
laws or the public policy underlying such laws.
(p) The Company is not involved in any labor dispute nor, to the
knowledge of the Company, is any such dispute threatened, which dispute would
have a Material Adverse
7.
<PAGE> 8
Effect. The Company is not aware of any existing or imminent labor disturbance
by the employees of any of its principal suppliers or contractors which would
have a Material Adverse Effect. The Company is not aware of any threatened or
pending litigation between the Company and any of its executive officers which,
if adversely determined, could have a Material Adverse Effect and has no reason
to believe that such officers will not remain in the employment of the Company.
(q) No transaction has occurred between or among the Company and
any of its officers or directors or five percent shareholders or any affiliate
or affiliates of any such officer or director or five percent shareholders that
is required to be described in and is not described in the Registration
Statement and the Prospectus.
(r) The Company has not taken, nor will it take, directly or
indirectly, any action designed to or which might reasonably be expected to
cause or result in, or which has constituted or which might reasonably be
expected to constitute, the stabilization or manipulation of the price of the
Common Stock to facilitate the sale or resale of any of the Shares.
(s) The Company has filed all Federal, state, local and foreign
tax returns which are required to be filed through the date hereof, or has
received extensions thereof, and has paid all taxes shown on such returns and
all assessments received by it to the extent that the same are material and have
become due, and there are no tax audits or investigations pending, which if
adversely determined would have a Material Adverse Effect; nor, to the knowledge
of the Company, are there any material proposed additional tax assessments
against the Company.
(t) The Shares have been duly authorized for quotation on the
Nasdaq National Market System, subject to official Notice of Issuance, and a
registration statement has been filed on Form 8-A pursuant to Section 12 of the
Securities Exchange Act of 1934, as amended (the "Exchange Act"), which
registration statement complies in all material respects with the Exchange Act.
(u) The Company has complied with all of the requirements and
filed the required forms as specified in Florida Statutes Section 517.075.
(v) The books, records and accounts of the Company accurately and
fairly reflect, in reasonable detail, the transactions in, and dispositions of,
the assets of, and the results of operations of, the Company. The Company
maintains a system of internal accounting controls sufficient to provide
reasonable assurances that (i) transactions are executed in accordance with
management's general or specific authorizations, (ii) transactions are recorded
as necessary to permit preparation of financial statements in accordance with
generally accepted accounting principles and to maintain asset accountability,
(iii) access to assets is permitted only in accordance with management's general
or specific authorization and (iv) the recorded accountability for assets is
compared with the existing assets at reasonable intervals and appropriate action
is taken with respect to any differences.
(w) The Company is insured by insurers of recognized financial
responsibility against such losses and risks and in such amounts as are
customary in the businesses in which it is engaged or propose to engage after
giving effect to the transactions described in the
8.
<PAGE> 9
Prospectus; and the Company has no reason to believe that it will not be able to
renew its existing insurance coverage as and when such coverage expires or to
obtain similar coverage from similar insurers as may be necessary to continue
its business at a cost that would not have a Material Adverse Effect. The
Company has not been denied any insurance coverage which it has sought or for
which it has applied.
(x) Each approval, consent, order, authorization, designation,
declaration or filing of, by or with any regulatory, administrative or other
governmental body necessary in connection with the execution and delivery by the
Company of this Agreement and the consummation of the transactions herein
contemplated required to be obtained or performed by the Company (except such
additional steps as may be required by the National Association of Securities
Dealers, Inc. (the "NASD") or may be necessary to qualify the Shares for public
offering by the Underwriters under the state securities or Blue Sky laws) has
been obtained or made and is in full force and effect.
(y) There are no affiliations with the NASD among the Company's
officers, directors or, to the best of the knowledge of the Company, any five
percent or greater shareholder of the Company, except as set forth in the
Registration Statement or otherwise disclosed in writing to the Representatives
of the Underwriters.
(z) (i) The Company is in compliance in all material respects
with all rules, laws and regulation relating to the use, treatment, storage and
disposal of toxic substances and protection of health or the environment
("Environmental Law") which are applicable to its business; (ii) the Company has
not received any notice from any governmental authority or third party of an
asserted claim under Environmental Laws; (iii) the Company has received all
permits, licenses or other approvals required of it under applicable
Environmental Laws to conduct its business and is in compliance with all terms
and conditions of any such permit, license or approval; (iv) to the Company's
knowledge, no facts currently exist that will require the Company to make future
material capital expenditures to comply with Environmental Laws; and (v) no
property which is or has been owned, leased or occupied by the Company has been
designated as a Superfund site pursuant to the Comprehensive Environmental
Response, Compensation of Liability Act of 1980, as amended (42 U.S.C. Section
9601, et. seq.) or otherwise designated as a contaminated site under applicable
state or local law.
(aa) The Company is not and, after giving effect to the offering
and sale of the Shares and the application of proceeds thereof as described in
the Prospectus, will not be an "investment company" within the meaning of the
Investment Company Act of 1940, as amended (the "Investment Company Act").
(bb) The Company or any other person associated with or acting on
behalf of the Company including, without limitation, any director, officer,
agent or employee of the Company has, to the Company's knowledge, directly or
indirectly, while acting on behalf of the Company (i) used any corporate funds
for unlawful contributions, gifts, entertainment or other unlawful expenses
relating to political activity; (ii) made any unlawful payment to foreign or
domestic government officials or employees or to foreign or domestic political
parties or campaigns from corporate funds; (iii) violated any provision of the
Foreign Corrupt Practices Act of 1977, as amended; or (iv) made any other
unlawful payment.
9.
<PAGE> 10
(cc) There are no issues of a material nature related to the
Company's preparedness for the Year 2000 that (i) are of a character required to
be described or referred to in the Registration Statement or Prospectus by the
Securities Act which have not been accurately described in the Registration
Statement or Prospectus or (ii) might reasonably be expected to result in any
Material Adverse Effect or that might materially affect their properties, assets
or rights. All internal computer systems and each Constituent Component (as
defined below) of those systems and all computer-related products and each
Constituent Component (as defined below) of those products of the Company fully
comply with Year 2000 Qualification Requirements. "Year 2000 Qualifications
Requirements" means that the internal computer systems and each Constituent
Component (as defined below) of those systems and all computer-related products
and each Constituent Component (as defined below) of those products of the
Company (i) have been reviewed to confirm that they store, process (including
sorting and performing mathematical operations, calculations and computations),
input and output data containing date and information correctly regardless of
whether the date contains dates and times before, on or after January 1, 2000,
(ii) have been designated to ensure date and time entry recognition and
calculations, and date data interface values that reflect the century, (iii)
accurately manage and manipulate data involving dates and times, including
single century formulas and multi-century formulas, and will not cause an
abnormal ending scenario within the application or generate incorrect values or
invalid results involving such dates, (iv) accurately process any date rollover,
and (v) accept and respond to two-digit year date input in a manner that
resolves any ambiguities as to the century. "Constituent Component" means all
software (including operating systems, programs, packages and utilities),
firmware, hardware, networking components, and peripherals provided as part of
the configuration. The Company has inquired of material vendors as to their
preparedness for the Year 2000 and has disclosed in the Registration Statement
or Prospectus any issues that might reasonably be expected to result in any
Material Adverse Effect.
5. REPRESENTATIONS AND WARRANTIES OF THE SELLING SHAREHOLDERS. Each of
the Selling Shareholders hereby represents and warrants, severally and not
jointly, to each Underwriter as follows:
(a) The Selling Shareholder has caused certificates for the
number of Shares to be sold by such Selling Shareholder hereunder to be
delivered to _______________ (the "Custodian"), endorsed in blank or with blank
stock powers duly executed, with a signature appropriately guaranteed, such
certificates to be held in custody by the Custodian for delivery, pursuant to
the provisions of this Agreement and an agreement dated ____________, 1999
between the Custodian and the Selling Shareholder (the "Custody Agreement").
(b) The Selling Shareholder has granted an irrevocable power of
attorney (the "Power of Attorney") to the person named therein, on behalf of the
Selling Shareholder, to execute and deliver this Agreement and any other
document necessary or desirable in connection with the transactions contemplated
hereby and to deliver the shares to be sold by the Selling Shareholder pursuant
hereto.
(c) This Agreement, the Custody Agreement, the Power of Attorney
and the Lock-Up Agreement have each been duly authorized, executed and delivered
by or on behalf of the Selling Shareholder and, assuming due authorization,
execution and delivery by the other
10.
<PAGE> 11
parties hereto, constitutes the valid and legally binding agreement of the
Selling Shareholder, enforceable against the Selling Shareholder in accordance
with its terms, except (i) as the enforceability thereof may be limited by
bankruptcy, insolvency, reorganization, moratorium or other similar laws
affecting the enforcement of creditors' rights generally and by general
equitable principles and (ii) to the extent that rights to indemnity or
contribution under this Agreement may be limited by Federal and state securities
laws or the public policy underlying such laws.
(d) The execution and delivery by the Selling Shareholder of this
Agreement and the performance by the Selling Shareholder of its obligations
under this Agreement (i) will not contravene any provision of applicable law,
statute, regulation or filing or any agreement or other instrument binding upon
the Selling Shareholder or any judgment, order or decree of any governmental
body, agency or court having jurisdiction over the Selling Shareholder, (ii)
does not require any consent, approval, authorization or order of or
registration or filing with any court or governmental agency or body having
jurisdiction over it, except (assuming the accuracy of Section 4(x) above) such
as may be required by the securities and Blue Sky laws of the various states and
any actions required by the NASD in connection with the offer and sale of the
Shares which have been or will be effected in accordance with this Agreement,
(iii) does not and will not violate any statute, law, regulation or filing or
judgment, injunction, order or decree applicable to the Selling Shareholder or
(iv) will not result in the creation or imposition of any lien, charge or
encumbrance upon any property or assets of the Selling Shareholder pursuant to
the terms of any agreement or instrument to which the Selling Shareholder is a
party or by which the Selling Shareholder may be bound or to which any of the
property or assets of the Selling Shareholder is subject, except in each case as
would not have a material adverse effect on the Selling Shareholder's ability to
perform his or her obligations hereunder.
(e) The Selling Shareholder has, and on the Firm Shares Closing
Date will have, good and marketable title to the Shares to be sold by the
Selling Shareholder free and clear of any lien, claim, security interest or
other encumbrance, including, without limitation, any restriction on transfer,
except as otherwise described in the Registration Statement and Prospectus.
(f) The Selling Shareholder has, and on the Firm Shares Closing
Date will have, full legal right, power and authorization, and any approval
required by law, to sell, assign, transfer and deliver the Shares to be sold by
the Selling Shareholder in the manner provided by this Agreement.
(g) Upon delivery of and payment for the Shares to be sold by the
Selling Shareholder pursuant to this Agreement, the several Underwriters will
receive good and marketable title to such Shares free and clear of any lien,
claim, security interest or other encumbrance.
(h) All information relating to the Selling Shareholder furnished
in writing by the Selling Shareholder expressly for use in the Registration
Statement is, and on each Closing Date will be, true, correct, and complete, and
does not, and on each Closing Date will not, contain any untrue statement of a
material fact or omit to state any material fact necessary to make such
information not misleading. All information relating to the Selling Shareholder
11.
<PAGE> 12
furnished in writing by the Selling Shareholder expressly for use in the
Prospectus is, and on each Closing Date will be, true, correct, and complete,
and does not, and on each Closing Date will not, contain any untrue statement of
a material fact or omit to state any material fact necessary to make such
information not misleading.
(i) The Affiliated Selling Shareholder has reviewed the
Registration Statement and Prospectus and, although the Affiliated Selling
Shareholder has not independently verified the accuracy or completeness of all
the information contained therein, nothing has come to the attention of the
Affiliated Selling Shareholder that would lead the Affiliated Selling
Shareholder to believe that (i) on the Effective Date, the Registration
Statement contained any untrue statement of a material fact or omitted to state
any material fact required to be stated therein in order to make the statements
made therein not misleading and (ii) on the Effective Date the Prospectus
contained and, on each Closing Date contains, no untrue statement of a material
fact or omitted or omits to state any material fact necessary in order to make
the statements therein, in the light of the circumstances under which they were
made, misleading.
(j) The sale of Shares by the Selling Shareholder pursuant to
this Agreement is not prompted by the Selling Shareholder's knowledge of any
material information concerning the Company which is not set forth in the
Prospectus.
(k) The Selling Shareholder has not taken and will not take,
directly or indirectly, any action designed to or that might reasonably be
expected to cause or result in stabilization or manipulation of the price of any
security of the Company to facilitate the sale or resale of the Shares.
(l) The Affiliated Selling Shareholder has no actual knowledge
that any representation or warranty of the Company set forth in Section 4 above
is untrue or inaccurate in any material respect.
(m) The representations and warranties of the Selling Shareholder
in the Custody Agreement are and on each Closing Date will be, true and correct.
6. CONDITIONS OF THE UNDERWRITERS' OBLIGATIONS. The obligations of the
Underwriters under this Agreement are several and not joint. The respective
obligations of the Underwriters to purchase the Shares are subject to each of
the following terms and conditions:
(a) Notification that the Registration Statement has become
effective shall have been received by the Representatives and the Prospectus
shall have been timely filed with the Commission in accordance with Section 7(a)
of this Agreement.
(b) No order preventing or suspending the use of any preliminary
prospectus or the Prospectus shall have been or shall be in effect and no order
suspending the effectiveness of the Registration Statement shall be in effect
and no proceedings for such purpose shall be pending before or threatened by the
Commission, and any requests for additional information on the part of the
Commission (to be included in the Registration Statement or the Prospectus or
otherwise) shall have been complied with to the satisfaction of the Commission
and the Representatives.
12.
<PAGE> 13
(c) The representations and warranties of the Company and the
Selling Shareholders contained in this Agreement and in the certificates
delivered pursuant to Section 6(d) shall be true and correct when made and on
and as of each Closing Date as if made on such date and the Company and the
Selling Shareholders shall have performed all covenants and agreements and
satisfied all the conditions contained in this Agreement required to be
performed or satisfied by them at or before such Closing Date.
(d) The Representatives shall have received on each Closing Date
a certificate, addressed to the Representatives and dated such Closing Date, of
the chief executive or chief operating officer and the chief financial officer
or chief accounting officer of the Company, in their capacities as officers of
the Company, to the effect that (i) the signers of such certificate have
carefully examined the Registration Statement, the Prospectus and this Agreement
and that the representations and warranties of the Company in this Agreement are
true and correct on and as of such Closing Date with the same effect as if made
on such Closing Date and the Company has performed all covenants and agreements
and satisfied all conditions contained in this Agreement required to be
performed or satisfied by it at or prior to such Closing Date, and (ii) no stop
order suspending the effectiveness of the Registration Statement has been issued
and to the best of their knowledge, no proceedings for that purpose have been
instituted or are pending under the Securities Act.
(e) The Representatives shall have received on each Closing Date
a certificate, addressed to the Representatives and dated such Closing Date, of
the Affiliated Selling Shareholder, to the effect that the Affiliated Selling
Shareholder has carefully examined the Registration Statement, the Prospectus
and this Agreement and a certificate, addressed to the Representatives and dated
such Closing Date, of each Selling Shareholder that the representations and
warranties of such Selling Shareholder in this Agreement are true and correct on
and as of such Closing Date with the same effect as if made on such Closing Date
and such Selling Shareholder has performed all covenants and agreements and
satisfied all conditions contained in this Agreement required to be performed or
satisfied by him or her at or prior to such Closing Date.
(f) The Representatives shall have received on the Effective
Date, at the time this Agreement is executed and on each Closing Date a signed
letter from PricewaterhouseCoopers LLP addressed to the Representatives and
dated, respectively, the Effective Date, the date of this Agreement and each
such Closing Date, in form and substance reasonably satisfactory to the
Representatives, confirming that they are independent accountants within the
meaning of the Securities Act and the Rules, that the response to Item 10 of the
Registration Statement is correct insofar as it relates to them and stating in
effect that:
(i) in their opinion the audited financial statements and
financial statement schedules included in the Registration Statement and the
Prospectus and reported on by them comply as to form in all material respects
with the applicable accounting requirements of the Securities Act and the Rules;
(ii) on the basis of a reading of the amounts included in
the Registration Statement and the Prospectus under the headings "Summary
Financial Information" and "Selected Financial Data," carrying out certain
procedures (but not an examination in
13.
<PAGE> 14
accordance with generally accepted auditing standards) which would not
necessarily reveal matters of significance with respect to the comments set
forth in such letter, a reading of the minutes of the meetings of the
shareholders and directors of the Company, and inquiries of certain officials of
the Company who have responsibility for financial and accounting matters of the
Company as to transactions and events subsequent to the date of the latest
audited financial statements, except as disclosed in the Registration Statement
and the Prospectus, nothing came to their attention which caused them to believe
that:
(1) the amounts in "Summary Financial Information,"
and "Selected Financial Data" included in the Registration Statement and the
Prospectus do not agree with the corresponding amounts in the audited and
unaudited financial statements from which such amounts were derived; or
(2) with respect to the Company, there were, at a
specified date not more than five business days prior to the date of the letter,
any increases in the current liabilities and long-term liabilities of the
Company or any decreases in net income or in working capital or the
shareholders' equity in the Company, as compared with the amounts shown on the
Company's audited balance sheet for the fiscal year ended September 30, 1998 and
the six months ended March 31, 1999 included in the Registration Statement; and
(iii) they have performed certain other procedures as may
be permitted under Generally Acceptable Auditing Standards as a result of which
they determined that certain information of an accounting, financial or
statistical nature (which is limited to accounting, financial or statistical
information derived from the general accounting records of the Company) set
forth in the Registration Statement and the Prospectus and reasonably specified
by the Representatives agrees with the accounting records of the Company.
(iv) based upon the procedures set forth in clauses (ii)
and (iii) above and a reading of the amounts included in the Registration
Statement under the headings "Summary Financial and Other Data" and "Selected
Financial Data" included in the Registration Statement and Prospectus and a
reading of the financial statements from which certain of such data were
derived, nothing has come to their attention that gives them reason to believe
that the "Summary Financial and Other Data" and "Selected Financial Data"
included in the Registration Statement and Prospectus do not comply as to the
form in all material respects with the applicable accounting requirements of the
Securities Act and the Rules or that the information set forth therein is not
fairly stated in relation to the financial statements included in the
Registration Statement or Prospectus from which certain of such data were
derived are not in conformity with generally accepted accounting principles
applied on a basis substantially consistent with that of the audited financial
statements included in the Registration Statement and Prospectus.
References to the Registration Statement and the Prospectus in this
paragraph (f) are to such documents as amended and supplemented at the date of
the letter.
(g) The Representatives shall have received on each Closing Date
from Lane Powell Spears Lubersky LLP counsel for the Company, an opinion,
addressed to the Representatives and dated such Closing Date, in the form
attached hereto as Exhibit A and stating in effect that:
14.
<PAGE> 15
(i) The Company has been duly organized and is validly
existing as a corporation in good standing under the laws of the State of
Washington. To the best of such counsel's knowledge, the Company has no
subsidiary and does not control, directly or indirectly, any corporation,
partnership, joint venture, association or other business organization. The
Company is duly qualified and in good standing as a foreign corporation in each
jurisdiction in which the character or location of its assets or properties
(owned, leased or licensed) or the nature of its businesses makes such
qualification necessary, except for such jurisdictions where the failure to so
qualify would not have a Material Adverse Effect.
(ii) The Company has all requisite corporate power and
authority to own, lease and license its assets and properties and conduct its
business as now being conducted and as described in the Registration Statement
and the Prospectus and to enter into, deliver and perform this Agreement and to
issue and sell the Shares other than those required under the Securities Act and
state and foreign Blue Sky laws.
(iii) The Company has authorized and issued capital stock
as set forth in the Registration Statement and the Prospectus under the caption
"Capitalization"; the certificates evidencing the Shares are in due and proper
legal form and have been duly authorized for issuance by the Company; all of the
outstanding shares of Common Stock of the Company have been duly and validly
authorized and issued and are fully paid and nonassessable and, to the knowledge
of such counsel, none of them was issued in violation of any preemptive or other
similar right. The Shares when issued and sold pursuant to this Agreement will
be duly and validly issued, outstanding, fully paid and nonassessable and, to
the knowledge of such counsel, none of them will have been issued in violation
of any preemptive or other similar right. To the best of such counsel's
knowledge, except as disclosed in the Registration Statement and the Prospectus,
there are no preemptive rights or any restriction upon the voting or transfer of
any securities of the Company pursuant to the Company's Articles of
Incorporation or bylaws or other governing documents or any other instrument to
which the Company is a party or by which it may be bound. To the best of such
counsel's knowledge, except as disclosed in the Registration Statement and the
Prospectus, there is no outstanding option, warrant or other right calling for
the issuance of, and no commitment, plan or arrangement to issue, any share of
stock of the Company or any security convertible into, exercisable for, or
exchangeable for stock of the Company. The Common Stock and the Shares conform
in all material respects to the descriptions thereof contained in the
Registration Statement and the Prospectus.
(iv) Each of the Lock-Up Agreements executed by the
Company's shareholders, directors and officers has been duly and validly
delivered by such persons and constitutes the legal, valid and binding
obligation of each such person enforceable against each such person in
accordance with its terms, except as the enforceability thereof may be limited
by applicable bankruptcy, insolvency, reorganization, moratorium or other
similar laws affecting the enforcement of creditors' rights generally and by
general equitable principles.
(v) All necessary corporate action has been duly and
validly taken by the Company to authorize the execution, delivery and
performance of this Agreement and the issuance and sale of the Shares. This
Agreement has been duly and validly authorized, executed and delivered by the
Company, and this Agreement constitutes the legal, valid and binding obligation
of the Company enforceable against the Company in accordance with its terms
except
15.
<PAGE> 16
(A) as such enforceability may be limited by applicable bankruptcy, insolvency,
reorganization, moratorium or other similar laws affecting the enforcement of
creditors' rights generally and by general equitable principles and (B) to the
extent that rights to indemnity or contribution under this Agreement may be
limited by Federal or state securities laws or the public policy underlying such
laws.
(vi) Neither the execution, delivery and performance of
this Agreement by the Company nor the consummation of any of the transactions
contemplated hereby (including, without limitation, the issuance and sale by the
Company of the Shares) will give rise to a right to terminate or accelerate the
due date of any payment due under, or conflict with or result in the breach of
any term or provision of, or constitute a default (or any event which with
notice or lapse of time, or both, would constitute a default) under, or require
consent or waiver under, or result in the execution or imposition of any lien,
charge or encumbrance upon any properties or assets of the Company pursuant to
the terms of any indenture, mortgage, deed trust, note or other agreement or
instrument of which such counsel is aware and to which the Company is a party or
by which it or any of its properties or businesses is bound, or any franchise,
license, permit, judgment, decree, order, statute, rule or regulation of which
such counsel is aware or violate any provision of the charter or bylaws of the
Company.
(vii) To the best of such counsel's knowledge, no default
exists, and no event has occurred which with notice or lapse of time, or both,
would constitute a default, in the due performance and observance of any term,
covenant or condition by the Company of any indenture, mortgage, deed of trust,
note or any other agreement or instrument to which the Company is a party or by
which it or any of its assets or properties or businesses may be bound or
affected, where the consequences of such default would have a Material Adverse
Effect.
(viii) To the best of such counsel's knowledge, the
Company is not in violation of any term or provision of its charter or by-laws
or any franchise, license, permit, judgment, decree, order, statute, rule or
regulation, where the consequences of such violation would have a Material
Adverse Effect.
(ix) No consent, approval, authorization or order of any
court or governmental agency or regulatory body is required for the execution,
delivery or performance of this Agreement by the Company or the consummation of
the transactions contemplated hereby or thereby, except such as have been
obtained under the Securities Act and such as may be required under state
securities or Blue Sky laws in connection with the purchase and distribution of
the Shares by the several Underwriters.
(x) To the best of such counsel's knowledge, except as
described in the Prospectus, there is no litigation or governmental or other
proceeding or investigation, before any court or before or by any public body or
board pending or threatened against, or involving the assets, properties or
businesses of, the Company which would have a Material Adverse Effect.
(xi) The statements in the Prospectus under the captions
"Description of Capital Stock" and "Shares Eligible for Future Sale" insofar as
such statements constitute a summary of documents referred to therein or matters
of law, are fair summaries in all material
16.
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respects and accurately present the information called for with respect to such
documents and legal matters. Accurate copies of all material contracts and other
documents required to be filed as exhibits to, or described in, the Registration
Statement have been so filed with the Commission or are fairly described in the
Registration Statement, as the case may be.
(xii) The Registration Statement, all preliminary
prospectuses and the Prospectus and each amendment or supplement thereto (except
for the financial statements and schedules and other financial and statistical
data included therein, as to which such counsel expresses no opinion) comply as
to form in all material respects with the requirements of the Securities Act and
the Rules.
(xiii) The Registration Statement is effective under the
Securities Act, and no stop order suspending the effectiveness of the
Registration Statement has been issued and no proceedings for that purpose have
been instituted or are threatened, pending or contemplated. Any required filing
of the Prospectus and any supplement thereto pursuant to Rule 424(b) under the
Securities Act has been made in the manner and within the time period required
by such Rule 424(b).
(xiv) The Shares have been approved for listing on the
Nasdaq National Market.
(xv) The capital stock of the Company conforms in all
material respects to the description thereof contained in the Prospectus under
the caption "Description of Capital Stock."
(xvi) The Company is not an "investment company" or an
entity controlled by an "investment company" as such terms are defined in the
Investment Company Act of 1940, as amended.
To the extent deemed advisable by such counsel, they may rely as to
matters of fact on certificates of responsible officers of the Company and
public officials and on the opinions of other counsel satisfactory to the
Representatives as to matters which are governed by laws other than the laws of
the State of Washington and the Federal laws of the United States; provided that
such counsel shall state that in their opinion to the Underwriters and they are
justified in relying on such other opinions. Copies of such certificates and
other opinions shall be furnished to the Representatives and counsel for the
Underwriters.
In addition, such counsel shall state that such counsel has participated
in conferences with officers and other representatives of the Company,
representatives of the Representatives and representatives of the independent
certified public accountants of the Company, at which conferences the contents
of the Registration Statement and the Prospectus and related matters were
discussed and, although such counsel is not passing upon and does not assume any
responsibility for the accuracy, completeness or fairness of the statements
contained in the Registration Statement and the Prospectus (except as expressly
stated in the foregoing opinion), on the basis of the foregoing, no facts have
come to the attention of such counsel which lead such counsel to believe that
the Registration Statement at the time it became effective (except with respect
to the financial statements and notes and schedules thereto and other financial
data, as to which such counsel need express no belief) contained any untrue
statement of a material
17.
<PAGE> 18
fact or omitted to state a material fact required to be stated therein or
necessary to make the statements therein not misleading, or that the Prospectus
as amended or supplemented (except with respect to the financial statements,
notes and schedules thereto and other financial data, as to which such counsel
need make no statement) on the date thereof contained any untrue statement of a
material fact or omitted to state a material fact necessary in order to make the
statements therein, in the light of the circumstances under which they were
made, not misleading.
(h) The Representatives shall have received on each Closing Date
from Seed and Berry LLP, patent counsel for the Company, an opinion, addressed
to the Representatives and dated such Closing Date, in the form of attached as
Exhibit B and stating in effect that:
(i) To the best of such counsel's knowledge, the Company
has not received notice of any claim of infringement of any patent, except as
set forth in the Registration Statement and the Prospectus; and
(ii) Such counsel has reviewed the Registration Statement
and Prospectus, the amendments and supplements thereto, and insofar as they
concern patents, patent rights or patent licenses, such counsel has no reason to
believe that either the Registration Statement or the Prospectus or any
amendment or supplement thereto (including particularly the information in the
Prospectus under the captions "Risk Factors--We Have Limited Protection of Our
Intellectual Property and Proprietary Technology", "--We Are Subject to Risks of
Infringement" and "--We Are Involved in Intellectual Property Disputes and
Cannot Predict the Likelihood or Impact of an Unfavorable Outcome",
"Business--Intellectual Property" and "--Legal Matters") contains any untrue
statement of a material fact or omits to state a material fact necessary to make
the statements therein not misleading.
In addition, in such opinion, such counsel (i) shall state that they
have represented the Company as to patent matters, are knowledgeable about its
technologies and have discussed such technologies with engineers for the
Company, (ii) may state that insofar as such opinion related to factual matters,
it is based upon certificates by officers of the Company, provided that such
counsel shall state that they believe that both you and they are justified in
relying upon such certificates and (iii) shall state that the Representatives
may rely on the opinions expressed in the letter dated June 22, 1999, and any
supplements thereto, from such counsel to Lane Powell Spears Lubersky LLP
regarding Analysis of U.S. Patent No. 5,884,033 to Duvall et al., a copy of
which shall be attached to such opinion delivered pursuant to this Section 6(h),
as if such letter had originally been delivered to the Representatives.
(i) The Representatives shall have received on the Firm Shares
Closing Date from Perkins Coie LLP, counsel for the Selling Shareholders, an
opinion, addressed to the Representatives and dated such Closing Date, in the
form attached hereto as Exhibit C and stating in effect that:
(i) This Agreement has been duly and validly executed and
delivered by or on behalf of the Selling Shareholders.
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<PAGE> 19
(ii) This Agreement, the Custody Agreement, the Power of
Attorney and the Lock-Up Agreement each constitute the legal, valid and binding
obligation of each Selling Shareholder enforceable against such Selling
Shareholder in accordance with its terms except (A) as such enforceability may
be limited by applicable bankruptcy, insolvency, reorganization, moratorium or
other similar laws affecting the enforcement of creditors' rights generally and
by general equitable principles and (B) to the extent that rights to indemnity
or contribution under this Agreement may be limited by Federal or state
securities laws or the public policy underlying such laws; and each Selling
Shareholder has full legal right and authority to enter into this Agreement and
to sell, transfer and deliver in the manner provided in this Agreement, the
Shares to be sold by such Selling Shareholder hereunder.
(iii) The transfer and sale by each Selling Shareholder of
the Shares to be sold by such Selling Shareholder as contemplated by this
Agreement will not conflict with, result in a breach of, or constitute a default
under any agreement or instrument known to such counsel to which such Selling
Shareholder is a party or by which such Selling Shareholder or any of its
properties may be bound, or any franchise, license, permit, judgment, decree,
order, statute, rule or regulation.
(iv) All of the rights of each Selling Shareholder in the
Shares to be sold by such Selling Shareholder pursuant to this Agreement, have
been transferred to the Underwriters who have severally purchased such Shares
pursuant to this Agreement, free and clear of adverse claims, assuming for
purposes of this opinion that the Underwriters purchased the same in good faith
without notice of any adverse claims.
(v) No consent, approval, authorization, license,
certificate, permit or order of any court, governmental or regulatory agency,
authority or body or financial institution is required in connection with the
performance of this Agreement by the Selling Shareholders or the consummation of
the transactions contemplated hereby, including the delivery and sale of the
Shares to be delivered and sold by the Selling Shareholders, except such as may
be required under state securities or blue sky laws in connection with the
purchase and distribution of the Shares by the several Underwriters.
To the extent deemed advisable by such counsel, they may rely as to
matters of fact on certificates of the Selling Shareholders and on the opinions
of other counsel satisfactory to the Representatives as to matters which are
governed by laws other than the laws of the States of Washington or the Federal
laws of the United States; provided that such counsel shall state that in their
opinion the Underwriters and they are justified in relying on such other
opinions. Copies of such certificates and other opinions shall be furnished to
the Representatives and counsel for the Underwriters.
(j) All proceedings taken in connection with the sale of the Firm
Shares and the Option Shares as herein contemplated shall be reasonably
satisfactory in form and substance to the Representatives, and their counsel and
the Underwriters shall have received from Cooley Godward LLP a favorable
opinion, addressed to the Representatives and dated such Closing Date, with
respect to the Shares, the Registration Statement and the Prospectus, and such
other related matters, as the Representatives may reasonably request, and the
Company shall have
19.
<PAGE> 20
furnished to Cooley Godward LLP such documents as they may reasonably request
for the purpose of enabling them to pass upon such matters.
(k) If the Shares have been qualified for sale in Florida, the
Representatives shall have received on each Closing Date certificates, addressed
to the Representatives, and dated such Closing Date, of an executive officer of
the Company, to the effect that the signer of such certificate has reviewed and
understands the provisions of Section 517.075 of the Florida Statutes, and
represents that the Company has complied, and at all times will comply, with all
provisions of Section 517.075 and further, that as of such Closing Date, neither
the Company nor any of its affiliates does business with the government of Cuba
or with any person or affiliate located in Cuba.
(l) The Representatives shall have received copies of the Lock-up
Agreements executed by each entity or person described in Section 4(n).
7. COVENANTS OF THE COMPANY.
(a) The Company covenants and agrees as follows:
(i) The Company shall prepare the Prospectus in a form
approved by the Representatives and file such Prospectus pursuant to Rule 424(b)
under the Securities Act not later than the Commission's close of business on
the second business day following the execution and delivery of this Agreement,
or, if applicable, such earlier time as may be required by Rule 430A(a)(3) under
the Securities Act.
(ii) The Company shall promptly advise the Representatives
in writing (i) when any amendment to the Registration Statement shall have
become effective, (ii) of any request by the Commission for any amendment of the
Registration Statement or the Prospectus or for any additional information,
(iii) of the prevention or suspension of the use of any preliminary prospectus
or the Prospectus or of the issuance by the Commission of any stop order
suspending the effectiveness of the Registration Statement or the institution or
threatening of any proceeding for that purpose and (iv) of the receipt by the
Company of any notification with respect to the suspension of the qualification
of the Shares for sale in any jurisdiction or the initiation or threatening of
any proceeding for such purpose. The Company shall not file any amendment of the
Registration Statement or supplement to the Prospectus unless the Company has
furnished the Representatives a copy for its review prior to filing and shall
not file any such proposed amendment or supplement to which the Representatives
reasonably object. The Company shall use its best efforts to prevent the
issuance of any such stop order and, if issued, to obtain as soon as possible
the withdrawal thereof.
(iii) If, at any time when a prospectus relating to the
Shares is required to be delivered under the Securities Act and the Rules, any
event occurs as a result of which the Prospectus as then amended or supplemented
would include any untrue statement of a material fact or omit to state any
material fact necessary to make the statements therein in the light of the
circumstances under which they were made not misleading, or if it shall be
necessary to amend or supplement the Prospectus to comply with the Securities
Act or the Rules, the Company promptly shall prepare and file with the
Commission, subject to the second sentence of
20.
<PAGE> 21
paragraph (ii) of this Section 7(a), an amendment or supplement which shall
correct such statement or omission or an amendment which shall effect such
compliance.
(iv) The Company shall make generally available to its
security holders and to the Representatives as soon as practicable, but not
later than 45 days after the end of the 12-month period beginning at the end of
the fiscal quarter of the Company during which the Effective Date occurs (or 90
days if such 12-month period coincides with the Company's fiscal year), an
earnings statement (which need not be audited) of the Company, covering such
12-month period, which shall satisfy the provisions of Section 11(a) of the
Securities Act or Rule 158 of the Rules.
(v) The Company shall furnish to the Representatives and
counsel for the Underwriters, without charge, signed copies of the Registration
Statement (including all exhibits thereto and amendments thereof) and to each
other Underwriter a copy of the Registration Statement (without exhibits
thereto) and all amendments thereof and, so long as delivery of a prospectus by
an Underwriter or dealer may be required by the Securities Act or the Rules, as
many copies of any preliminary prospectus and the Prospectus and any amendments
thereof and supplements thereto as the Representatives may reasonably request.
(vi) The Company shall cooperate with the Representatives
and their counsel in endeavoring to qualify the Shares for offer and sale in
connection with the offering under the laws of such jurisdictions as the
Representatives may designate and shall maintain such qualifications in effect
so long as required for the distribution of the Shares; provided, however, that
the Company shall not be required in connection therewith, as a condition
thereof, to qualify as a foreign corporation or to execute a general consent to
service of process in any jurisdiction or subject itself to taxation as doing
business in any jurisdiction.
(vii) For a period of five years after the date of this
Agreement, the Company shall supply to the Representatives, and to each other
Underwriter who may so request in writing, copies of such financial statements
and other periodic and special reports as the Company may from time to time
distribute generally to the holders of any class of its capital stock and to
furnish to the Representatives a copy of each annual or other report it shall be
required to file with the Commission.
(viii) Without the prior written consent of CIBC World
Markets Corp., for a period of 180 days after the date of this Agreement, the
Company and each of its individual directors and executive officers shall not
issue, sell or register with the Commission (other than on Form S-8 or on any
successor form), or otherwise dispose of, directly or indirectly, any equity
securities of the Company (or any securities convertible into, exercisable for
or exchangeable for equity securities of the Company), except for the issuance
of the Shares pursuant to the Registration Statement and the issuance of shares
pursuant to the Company's existing stock option plan or bonus plan as described
in the Registration Statement and the Prospectus. In the event that during this
period, (i) any shares are issued pursuant to the Company's existing stock
option plan or bonus plan that are exercisable during such 180 day period or
(ii) any registration is effected on Form S-8 or on any successor form relating
to shares that are exercisable during such 180 period, the Company shall obtain
the written agreement of such grantee or purchaser or holder of such registered
securities that, for a period of 180 days after the date of this Agreement,
21.
<PAGE> 22
such person will not, without the prior written consent of CIBC World Markets
Corp., offer for sale, sell, distribute, grant any option for the sale of, or
otherwise dispose of, directly or indirectly, or exercise any registration
rights with respect to, any shares of Common Stock (or any securities
convertible into, exercisable for, or exchangeable for any shares of Common
Stock) owned by such person.
(ix) On or before completion of this offering, the Company
shall make all filings required under applicable securities laws and by the
Nasdaq National Market (including any required registration under the Exchange
Act).
(x) The Company shall file timely and accurate reports in
accordance with the provisions of Florida Statutes Section 517.05, or any
successor provision, and any regulation promulgated thereunder, if at any time
after the Effective Date, the Company or any of its affiliates commences
engaging in business with the government of Cuba or any person or affiliate
located in Cuba.
(xi) The Company will apply the net proceeds from the
offering of the Shares in the manner set forth under "Use of Proceeds" in the
Prospectus.
(xii) If at any time during the 25-day period after the
Registration Statement becomes effective any rumor, publication or event
relating to or affecting the Company shall occur as a result of which in your
opinion the market price for the Shares has been or is likely to be materially
affected (regardless of whether such rumor, publication or event necessitates a
supplement to or amendment of the Prospectus), the Company will, after written
notice from you advising the Company to the effect set forth above, forthwith
prepare, consult with you concerning the substance of, and disseminate a press
release or other public statement, reasonably satisfactory to you, responding to
or commenting on such rumor, publication or event.
(xiii) The Company is familiar with the Investment Company
Act of 1940, as amended, and has in the past conducted its affairs, and does not
intend in the future to conduct its affairs, in such a manner to ensure that the
Company was not and will not be an "investment company" or a company
"controlled" by an "investment company" within the meaning of the Investment
Company Act of 1940, as amended, and the rules and regulations thereunder.
(b) The Company agrees to pay, or reimburse if paid by the
Representatives, whether or not the transactions contemplated hereby are
consummated or this Agreement is terminated, all costs and expenses incident to
the public offering of the Shares and the performance of the obligations of the
Company under this Agreement including those relating to: (i) the preparation,
printing, filing and distribution of the Registration Statement including all
exhibits thereto, each preliminary prospectus, the Prospectus, all amendments
and supplements to the Registration Statement and the Prospectus, and the
printing, filing and distribution of this Agreement; (ii) the preparation and
delivery of certificates for the Shares to the Underwriters; (iii) the
registration or qualification of the Shares for offer and sale under the
securities or Blue Sky laws of the various jurisdictions referred to in Section
7(a)(vi), including the reasonable fees and disbursements of counsel for the
Underwriters in connection with such registration and
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qualification and the preparation, printing, distribution and shipment of
preliminary and supplementary Blue Sky memoranda; (iv) the furnishing (including
costs of shipping and mailing) to the Representatives and to the Underwriters of
copies of each preliminary prospectus, the Prospectus and all amendments or
supplements to the Prospectus, and of the several documents required by this
Section to be so furnished, as may be reasonably requested for use in connection
with the offering and sale of the Shares by the Underwriters or by dealers to
whom Shares may be sold; (v) the filing fees of the NASD in connection with its
review of the terms of the public offering and reasonable fees and disbursements
of counsel for the Underwriters in connection with such review; (vi) the
furnishing (including costs of shipping and mailing) to the Representatives and
to the Underwriters of copies of all reports and information required by Section
7(a)(vii); (vii) inclusion of the Shares for quotation on the Nasdaq National
Market; and (viii) all transfer taxes, if any, with respect to the sale and
delivery of the Shares by the Company to the Underwriters. Subject to the
provisions of Section 10, the Underwriters agree to pay, whether or not the
transactions contemplated hereby are consummated or this Agreement is
terminated, all costs and expenses incident to the performance of the
obligations of the Underwriters under this Agreement not payable by the Company
pursuant to the preceding sentence, including, without limitation, the fees and
disbursements of counsel for the Underwriters.
(c) The Selling Shareholders will pay any transfer taxes incident
to the transfer to the Underwriters of the Shares being sold by the Selling
Shareholders.
8. INDEMNIFICATION.
(a) The Company and the Selling Shareholders agree, jointly and
severally, to indemnify and hold harmless each Underwriter and each person, if
any, who controls any Underwriter within the meaning of Section 15 of the
Securities Act or Section 20 of the Exchange Act from and against any and all
losses, claims, damages and liabilities, joint or several (including any
reasonable investigation, legal and other expenses incurred in connection with,
and any amount paid in settlement of, any action, suit or proceeding or any
claim asserted), to which they, or any of them, may become subject under the
Securities Act, the Exchange Act or other Federal or state law or regulation, at
common law or otherwise, insofar as such losses, claims, damages or liabilities
arise out of or are based upon (i) any untrue statement or alleged untrue
statement of a material fact contained in any preliminary prospectus, the
Registration Statement or the Prospectus or any amendment thereof or supplement
thereto, or arise out of or are based upon any omission or alleged omission to
state therein a material fact required to be stated therein or necessary to make
the statements therein not misleading, (ii) in whole or in part upon any breach
of the representations and warranties set forth in Section 4 hereof, or (iii) in
whole or in part upon any failure of the Company to perform any of its
obligations hereunder or under law; provided, however, that such indemnity shall
not inure to the benefit of any Underwriter (or any person controlling such
Underwriter) on account of any losses, claims, damages or liabilities arising
from the sale of the Shares to any person by such Underwriter if such untrue
statement or omission or alleged untrue statement or omission was made in such
preliminary prospectus, the Registration Statement or the Prospectus, or such
amendment or supplement, in reliance upon and in conformity with information
furnished in writing to the Company by the Representatives on behalf of any
Underwriter specifically for use therein. Notwithstanding the foregoing, the
liability of each Selling Shareholders pursuant to the
23.
<PAGE> 24
provisions of Section 8(a) shall be limited to an amount equal to the aggregate
net proceeds received by such Selling Shareholder from the sale of the Shares
sold by such Selling Shareholder hereunder. This indemnity agreement will be in
addition to any liability which the Company and the Selling Shareholders may
otherwise have.
(b) Each Underwriter agrees, severally and not jointly, to
indemnify and hold harmless the Company, the Selling Shareholders and each
person, if any, who controls the Company within the meaning of Section 15 of the
Securities Act or Section 20 of the Exchange Act, each director of the Company,
and each officer of the Company who signs the Registration Statement, to the
same extent as the foregoing indemnity from the Company and the Selling
Shareholders to each Underwriter, but only insofar as such losses, claims,
damages or liabilities arise out of or are based upon any untrue statement or
omission or alleged untrue statement or omission which was made in any
preliminary prospectus, the Registration Statement or the Prospectus, or any
amendment thereof or supplement thereto, contained in the last paragraph of the
cover page, in the paragraph relating to stabilization on the inside front cover
page of the Prospectus and the statements contained under the caption
"Underwriting" in the Prospectus; provided, however, that the obligation of each
Underwriter to indemnify the Company or the Selling Shareholders (including any
controlling person, director or officer thereof) shall be limited to the net
proceeds received by the Company from such Underwriter. This indemnity agreement
will be in addition to any liability the Underwriters may otherwise have.
(c) Any party that proposes to assert the right to be indemnified
under this Section will, promptly after receipt of notice of commencement of any
action, suit or proceeding against such party in respect of which a claim is to
be made against an indemnifying party or parties under this Section, notify each
such indemnifying party of the commencement of such action, suit or proceeding,
enclosing a copy of all papers served. No indemnification provided for in
Section 8(a) or 8(b) shall be available to any party who shall fail to give
notice as provided in this Section 8(c) if the party to whom notice was not
given was unaware of the proceeding to which such notice would have related and
was prejudiced by the failure to give such notice but the omission so to notify
such indemnifying party of any such action, suit or proceeding shall not relieve
it from any liability that it may have to any indemnified party for contribution
or otherwise than under this Section. In case any such action, suit or
proceeding shall be brought against any indemnified party and it shall notify
the indemnifying party of the commencement thereof, the indemnifying party shall
be entitled to participate in, and, to the extent that it shall wish, jointly
with any other indemnifying party similarly notified, to assume the defense
thereof, with counsel reasonably satisfactory to such indemnified party, and
after notice from the indemnifying party to such indemnified party of its
election so to assume the defense thereof and the approval by the indemnified
party of such counsel, the indemnifying party shall not be liable to such
indemnified party for any legal or other expenses, except as provided below and
except for the reasonable costs of investigation subsequently incurred by such
indemnified party in connection with the defense thereof. The indemnified party
shall have the right to employ its counsel in any such action, but the fees and
expenses of such counsel shall be at the expense of such indemnified party
unless (i) the employment of counsel by such indemnified party has been
authorized in writing by the indemnifying parties, (ii) the indemnified party
shall have reasonably concluded that there may be a conflict of interest between
the indemnifying parties and the indemnified party in the conduct of the defense
of such action (in which case the indemnifying parties shall not have the right
to direct the defense of such action on behalf of the
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<PAGE> 25
indemnified party) or (iii) the indemnifying parties shall not have employed
counsel to assume the defense of such action within a reasonable time after
notice of the commencement thereof, in each of which cases the fees and expenses
of counsel shall be at the expense of the indemnifying parties. An indemnifying
party shall not be liable for any settlement of any action, suit, proceeding or
claim effected without its written consent, which consent shall not be
unreasonably withheld or delayed.
9. CONTRIBUTION. In order to provide for just and equitable contribution
in circumstances in which the indemnification provided for in Section 8(a) or
8(b) is due in accordance with its terms but for any reason is held to be
unavailable to or insufficient to hold harmless an indemnified party under
Section 8(a) or 8(b), then each indemnifying party shall contribute to the
aggregate losses, claims, damages and liabilities (including any investigation,
legal and other expenses reasonably incurred in connection with, and any amount
paid in settlement of, any action, suit or proceeding or any claims asserted,
but after deducting any contribution received by any person entitled hereunder
to contribution from any person who may be liable for contribution) to which the
indemnified party may be subject in such proportion as is appropriate to reflect
the relative benefits received by the Company and the Selling Shareholders on
the one hand and the Underwriters on the other from the offering of the Shares
or, if such allocation is not permitted by applicable law or indemnification is
not available as a result of the indemnifying party not having received notice
as provided in Section 8 hereof, in such proportion as is appropriate to reflect
not only the relative benefits referred to above but also the relative fault of
the Company and the Selling Shareholders on the one hand and the Underwriters on
the other in connection with the statements or omissions which resulted in such
losses, claims, damages, liabilities or expenses, as well as any other relevant
equitable considerations. The relative benefits received by the Company, the
Selling Shareholders and the Underwriters shall be deemed to be in the same
proportion as (x) the total proceeds from the offering (net of underwriting
discounts but before deducting expenses) received by the Company or the Selling
Shareholders, as set forth in the table on the cover page of the Prospectus,
bear to (y) the underwriting discounts received by the Underwriters, as set
forth in the table on the cover page of the Prospectus. The relative fault of
the Company and the Selling Shareholders or the Underwriters shall be determined
by reference to, among other things, whether the untrue or alleged untrue
statement of a material fact related to information supplied by the Company and
the Selling Shareholders or the Underwriters and the parties' relative intent,
knowledge, access to information and opportunity to correct or prevent such
statement or omission. The Company and the Selling Shareholders and the
Underwriters agree that it would not be just and equitable if contribution
pursuant to this Section 9 were determined by pro rata allocation (even if the
Underwriters were treated as one entity for such purpose) or by any other method
of allocation which does not take account of the equitable considerations
referred to above. Notwithstanding the provisions of this Section 9, (i) in no
case shall any Underwriter (except as may be provided in the Agreement Among
Underwriters) be liable or responsible for any amount in excess of the
underwriting discount applicable to the Shares purchased by such Underwriter
hereunder; (ii) the Company shall be liable and responsible for any amount in
excess of such underwriting discount; and (iii) in no case shall any Selling
Shareholder be liable and responsible for any amount in excess of the aggregate
net proceeds of the sale of Shares received by such Selling Shareholder;
provided, however, that no person guilty of fraudulent misrepresentation (within
the meaning of Section 11(f) of the Securities Act) shall be entitled to
contribution from any person who was not guilty of such fraudulent
misrepresentation. For purposes of this Section 9, each person, if any,
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<PAGE> 26
who controls an Underwriter within the meaning of Section 15 of the Securities
Act or Section 20(a) of the Exchange Act shall have the same rights to
contribution as such Underwriter, and each person, if any, who controls the
Company or a Selling Shareholder within the meaning of the Section 15 of the
Securities Act or Section 20(a) of the Exchange Act, each officer of the Company
who shall have signed the Registration Statement and each director of the
Company shall have the same rights to contribution as the Company, subject in
each case to clauses (i), (ii) and (iii) in the immediately preceding sentence
of this Section 9. Any party entitled to contribution will, promptly after
receipt of notice of commencement of any action, suit or proceeding against such
party in respect of which a claim for contribution may be made against another
party or parties under this Section, notify such party or parties from whom
contribution may be sought, but the omission so to notify such party or parties
from whom contribution may be sought shall not relieve the party or parties from
whom contribution may be sought from any other obligation it or they may have
hereunder or otherwise than under this Section. No party shall be liable for
contribution with respect to any action, suit, proceeding or claim settled
without its written consent. The Underwriter's obligations to contribute
pursuant to this Section 9 are several in proportion to their respective
underwriting commitments and not joint.
10. TERMINATION. This Agreement may be terminated with respect to the
Shares to be purchased on a Closing Date by the Representatives by notifying the
Company and the Selling Shareholders at any time
(a) in the absolute discretion of the Representatives at or
before any Closing Date: (i) if on or prior to such date, any domestic or
international event or act or occurrence has materially disrupted, or in the
opinion of the Representatives will in the future materially disrupt, the
securities markets; (ii) if there has occurred any new outbreak or material
escalation of hostilities or other calamity or crisis the effect of which on the
financial markets of the United States is such as to make it, in the judgment of
the Representatives, inadvisable to proceed with the offering; (iii) if there
shall be such a material adverse change in general financial, political or
economic conditions or the effect of international conditions on the financial
markets in the United States is such as to make it, in the judgment of the
Representatives, inadvisable or impracticable to market the Shares; (iv) if
trading in the Shares has been suspended by the Commission or trading generally
on the New York Stock Exchange, Inc., on the American Stock Exchange, Inc. or
the Nasdaq National Market has been suspended or limited, or minimum or maximum
ranges for prices for securities shall have been fixed, or maximum ranges for
prices for securities have been required, by said exchanges or by order of the
Commission, the National Association of Securities Dealers, Inc., or any other
governmental or regulatory authority; or (v) if a banking moratorium has been
declared by any state or Federal authority; or (vi) if, in the judgment of the
Representatives, there has occurred a Material Adverse Effect, or
(b) at or before any Closing Date, that any of the conditions
specified in Section 6 shall not have been fulfilled when and as required by
this Agreement.
If this Agreement is terminated pursuant to any of its provisions,
neither the Company nor the Selling Shareholders shall be under any liability to
any Underwriter, and no Underwriter shall be under any liability to the Company,
except that (y) if this Agreement is terminated by the Representatives or the
Underwriters because of any failure, refusal or inability on the part of the
Company or the Selling Shareholders to comply with the terms or to fulfill any
of the conditions
26.
<PAGE> 27
of this Agreement, the Company will reimburse the Underwriters for all
out-of-pocket expenses (including the reasonable fees and disbursements of their
counsel) incurred by them in connection with the proposed purchase and sale of
the Shares or in contemplation of performing their obligations hereunder and (z)
no Underwriter who shall have failed or refused to purchase the Shares agreed to
be purchased by it under this Agreement, without some reason sufficient
hereunder to justify cancellation or termination of its obligations under this
Agreement, shall be relieved of liability to the Company, the Selling
Shareholders or to the other Underwriters for damages occasioned by its failure
or refusal.
11. SUBSTITUTION OF UNDERWRITERS. If one or more of the Underwriters
shall fail (other than for a reason sufficient to justify the cancellation or
termination of this Agreement under Section 10) to purchase on any Closing Date
the Shares agreed to be purchased on such Closing Date by such Underwriter or
Underwriters, the Representatives may find one or more substitute underwriters
to purchase such Shares or make such other arrangements as the Representatives
may deem advisable or one or more of the remaining Underwriters may agree to
purchase such Shares in such proportions as may be approved by the
Representatives, in each case upon the terms set forth in this Agreement. If no
such arrangements have been made by the close of business on the business day
following such Closing Date,
(a) if the number of Shares to be purchased by the defaulting
Underwriters on such Closing Date shall not exceed 10% of the Shares that all
the Underwriters are obligated to purchase on such Closing Date, then each of
the nondefaulting Underwriters shall be obligated to purchase such Shares on the
terms herein set forth in proportion to their respective obligations hereunder;
provided, that in no event shall the maximum number of Shares that any
Underwriter has agreed to purchase pursuant to Section 1 be increased pursuant
to this Section 11 by more than one-ninth of such number of Shares without the
written consent of such Underwriter, or
(b) if the number of Shares to be purchased by the defaulting
Underwriters on such Closing Date shall exceed 10% of the Shares that all the
Underwriters are obligated to purchase on such Closing Date, then the Company
shall be entitled to one additional business day within which it may, but is not
obligated to, find one or more substitute underwriters reasonably satisfactory
to the Representatives to purchase such Shares upon the terms set forth in this
Agreement.
In any such case, either the Representatives or the Company shall have
the right to postpone the applicable Closing Date for a period of not more than
five business days in order that necessary changes and arrangements (including
any necessary amendments or supplements to the Registration Statement or
Prospectus) may be effected by the Representatives and the Company. If the
number of Shares to be purchased on such Closing Date by such defaulting
Underwriter or Underwriters shall exceed 10% of the Shares that all the
Underwriters are obligated to purchase on such Closing Date, and none of the
nondefaulting Underwriters or the Company shall make arrangements pursuant to
this Section within the period stated for the purchase of the Shares that the
defaulting Underwriters agreed to purchase, this Agreement shall terminate with
respect to the Shares to be purchased on such Closing Date without liability on
the part of any nondefaulting Underwriter to the Company or the Selling
Shareholders and without liability on the part of the Company, except in both
cases as provided in Sections 7(b), 8, 9 and 10. The provisions of this Section
shall not in any way affect the liability of any
27.
<PAGE> 28
defaulting Underwriter to the Company, the Selling Shareholders or the
nondefaulting Underwriters arising out of such default. A substitute underwriter
hereunder shall become an Underwriter for all purposes of this Agreement.
12. MISCELLANEOUS. The respective agreements, representations,
warranties, indemnities and other statements of the Company or its officers, of
the Selling Shareholders and of the Underwriters set forth in or made pursuant
to this Agreement shall remain in full force and effect, regardless of any
investigation made by or on behalf of any Underwriter or the Company or the
Selling Shareholders or any of the officers, directors or controlling persons
referred to in Sections 8 and 9 hereof, and shall survive delivery of and
payment for the Shares. The provisions of Sections 7(b), 8, 9 and 10 shall
survive the termination or cancellation of this Agreement.
This Agreement has been and is made for the benefit of the Underwriters,
the Company and the Selling Shareholders and their respective successors and
assigns, and, to the extent expressed herein, for the benefit of persons
controlling any of the Underwriters, or the Company, and directors and officers
of the Company, and their respective successors and assigns, and no other person
shall acquire or have any right under or by virtue of this Agreement. The term
"successors and assigns" shall not include any purchaser of Shares from any
Underwriter merely because of such purchase.
All notices and communications hereunder shall be in writing and mailed
or delivered or by telephone or telegraph if subsequently confirmed in writing,
(a) if to the Representatives, c/o CIBC World Markets Corp., CIBC World Markets
Tower, World Financial Center, New York, New York 10281 Attention: Jennifer
Aranoff, Esq., with a copy to Gregory Abbott, Esq., Codley Goodward LLP, 5200
Carillon Point, Kirkland, Washington 98033-7355 and (b) if to the Company, to
its agent for service as such agent's address appears on the cover page of the
Registration Statement with a copy to Michael E. Morgan, Esq., Lane Powell
Spears Lubersky LLP, 1420 Fifth Avenue, Suite 4100, Seattle, Washington
98101-2338 and (c) if to the Selling Shareholders to Mark A. Segale, 18000
Andover Park West, Suite 200, Tukwila, Washington 98108 with a copy to Gregory
Gorder, Esq., Perkins Coie LLP, 1201 Third Avenue, 40th Floor, Seattle,
Washington 98101-3099.
This Agreement shall be governed by and construed in accordance with the
laws of the State of New York without regard to principles of conflict of laws.
This Agreement may be signed in any number of counterparts, each of
which shall be an original, with the same effect as if the signatures thereto
and hereto were upon the same instrument.
28.
<PAGE> 29
Please confirm that the foregoing correctly sets forth the agreement
among us.
Very truly yours,
ISSUER
By:
----------------------------------------
Title:
AFFILIATED SELLING SHAREHOLDER
By:
----------------------------------------
Mark Segale
SELLING SHAREHOLDER
By:
----------------------------------------
Title: Attorney In Fact
Confirmed:
CIBC WORLD MARKETS CORP.
- ----------------------------------------
Acting severally on behalf of itself
and as representative of the several
Underwriters named in Schedule I annexed hereto.
By CIBC WORLD MARKETS CORP.
By:
-------------------------------------
Title:
29.
<PAGE> 30
SCHEDULE I
UNDERWRITERS
<TABLE>
<CAPTION>
NUMBER OF FIRM
SHARES TO BE
NAME AND ADDRESS PURCHASED
- ---------------- ---------
<S> <C>
CIBC World Markets Corp.
U.S. Bancorp Piper Jaffray, Inc.
---------
TOTAL:..............................................
=========
</TABLE>
30.
<PAGE> 31
SCHEDULE II
SELLING SHAREHOLDERS
<TABLE>
<CAPTION>
NUMBER OF FIRM
SHARES TO BE
NAME AND ADDRESS SOLD
- ---------------- --------------
<S> <C>
Mark A. Segale(1) 28,445
Lisa M. Atkins 7,310
Tina A. Covey 7,310
Nita S. Johnson 3,610
Ann J. Nichols 1,845
Donna A. Segale 1,480
------
TOTAL:............................................................. 50,000
======
</TABLE>
- --------
(1) Affiliated Selling Shareholder
31.
<PAGE> 1
EXHIBIT 23.1
CONSENT OF INDEPENDENT ACCOUNTANTS
We hereby consent to the use in this Registration Statement on Form S-1 of our
report dated March 17, 1999, except as to the third through sixth paragraphs of
Note 12, which are as of May 11, 1999, and except as to the seventh paragraph of
Note 12 which is as of May 14, 1999, relating to the financial statements of
N2H2, Inc. which appears in such Registration Statement. We also consent to the
references to us under the headings "Experts" and "Selected Financial Data" in
such Prospectus. However, it should be noted that PricewaterhouseCoopers LLP has
not prepared or certified such "Selected Financial Data" in such Registration
Statement.
PricewaterhouseCoopers LLP
Seattle, Washington
July 20, 1999
